2008 Financial Crisis

The Causes and Costs of the Worst Crisis Since the Great Depression

© The Balance 2019

The 2008 financial crisis is the worst economic disaster since the Great Depression of 1929. It occurred despite Federal Reserve and Treasury Department efforts to prevent it.

It led to the Great Recession, where housing prices fell 33%—more than the price plunge during the Depression. Two years after the recession ended, unemployment was still above 9%, and that's not counting discouraged workers who had given up looking for work. 

Key Takeaways

  • The 2008 financial crisis was the biggest downturn since the 1929 crash. It kicked off the Great Recession.
  • The housing market created an asset bubble in 2006.
  • Banks offered loans to people who couldn’t afford them.
  • They bundled these loans and sold them as mortgage-backed securities.
  • Investors who bought these derivatives believed AIG insurance protected them.
  • When housing prices fell, it destroyed these derivatives' value. Many “too big to fail” banks faced ruin.
  • To halt a global crisis, Congress intervened with TARP and ARRA.
  • Congress then passed Dodd-Frank to regulate banks.

Causes of the Crisis

The first sign that the economy was in trouble occurred in 2006 when housing prices started to fall. At first, realtors applauded; they thought the overheated housing market would return to a more sustainable level. They didn't realize there were too many homeowners with questionable credit. Banks had allowed people to take out loans for 100% or more of the value of their new homes. Many blamed the Community Reinvestment Act, which pushed banks to make investments in subprime areas, but that wasn't the underlying cause. 

The Commodity Futures Modernization Act was arguably the real villain. It allowed banks to engage in trading profitable derivatives that they sold to investors. These mortgage-backed securities needed home loans as collateral. The derivatives created an insatiable demand for more and more mortgages.

The Federal Reserve didn't know how far the damage would spread and widely believed that the subprime mortgage crisis would remain confined to the housing sector. They didn't understand the actual causes of the subprime mortgage crisis until later. 

Hedge funds and other financial institutions around the world owned the mortgage-backed securities, but they were also in mutual funds, corporate assets, and pension funds. The banks had chopped up the original mortgages and resold them in tranches, making the derivatives impossible to price. 

Stodgy pension funds bought these risky assets because they thought an insurance product called credit default swaps protected them. A traditional insurance company known as the American Insurance Group (AIG) sold these swaps, and when the derivatives lost value, AIG didn't have enough cash flow to honor all the swaps.

More signs of the financial crisis appeared in 2007. Banks panicked when they realized they would have to absorb the losses, and they stopped lending to each other. They didn't want other banks giving them worthless mortgages as collateral. As a result, interbank borrowing costs, called Libor, rose. The Federal Reserve began pumping liquidity into the banking system via the Term Auction Facility, but that wasn't enough.

Cost of the Crisis

The chart below shows a breakdown of how much the 2008 financial crisis cost.

The 2008 financial crisis timeline began in March 2008, when investors sold off their shares of investment bank Bear Stearns because it had too many of the toxic assets. Bear approached JP Morgan Chase to bail it out. The Fed had to sweeten the deal with a $30 billion guarantee, and by 2012, the Fed had received full payment for its loan.

Instead, the situation on Wall Street deteriorated throughout the summer of 2008.

Congress authorized the Treasury Secretary to take over mortgage companies Fannie Mae and Freddie Mac, which cost it $187 billion at the time. Since then, the Treasury has made enough profit to pay off the cost.

On September 16, 2008, the Fed loaned $85 billion to AIG as a bailout. In October and November, the Fed and Treasury restructured the bailout, bringing the total amount to $182 billion. But by 2012, the government made a $22.7 billion profit when the Treasury sold its last AIG shares. The value of the company had risen that much in four years.

On September 17, 2008, the crisis created a run on money market funds. Companies park excess cash there to earn interest on it overnight, and banks then use those funds to make short-term loans. During the run, companies moved a record $172 billion out of their money market accounts into even safer Treasury bonds. If these accounts had gone bankrupt, business activities and the economy would have ground to a halt. That crisis called for massive government intervention. 

Three days later, Treasury Secretary Henry Paulson and Fed Chair Ben Bernanke submitted a $700 billion bailout package to Congress. Their fast response helped stopped the run, but Republicans blocked the bill for two weeks because they didn't want to bail out banks. They only approved the bill after global stock markets almost collapsed.

Troubled Asset Relief Program

The bailout package never cost taxpayers the full $700 billion. The Treasury disbursed $439.6 billion from the Troubled Asset Relief Program (TARP). By 2018, it had put $442.6 billion back into the fund, making $3 billion in profit. It did this by buying shares of the companies it bailed out when prices were low and wisely sold them when prices were high.

The TARP funds helped in five areas:

  1. $245.1 billion was used to buy bank preferred stocks as a way to give them cash.
  2. $80.7 billion bailed out auto companies.
  3. $69.8 billion went to the $182 billion bailout of AIG.
  4. $19.1 billion went to shore up credit markets. The banks repaid $23.6 billion, creating a $4.5 billion profit.
  5. The Homeowner Affordability and Stability Plan disbursed $27.9 billion to modify mortgages.

President Barack Obama didn't use the remaining $700 billion allocated for TARP because he didn't want to bail out any more businesses. Instead, he asked Congress for an economic stimulus package. On February 17, 2009, he signed the American Recovery and Reinvestment Act, which included tax cuts, stimulus checks, and public works spending. By 2011, it put $831 billion directly into the pockets of consumers and small businesses. That was enough to end the financial crisis by July 2009.

How It Could Happen Again

Some legislators blame Fannie and Freddie for the entire crisis. To them, the solution is to close or privatize the two agencies, but if they were shut down, the housing market would collapse because they guarantee the majority of mortgages. Furthermore, securitization, or the bundling and reselling of loans, has spread to more than just housing. The government must step in to regulate. Congress passed the Dodd-Frank Wall Street Reform Act to prevent banks from taking on too much risk. It allows the Fed to reduce bank size for those that become too big to fail. 

Meanwhile, banks keep getting bigger and are pushing to minimize or get rid of even this regulation. The financial crisis of 2008 proved that banks could not regulate themselves, and without government oversight like Dodd-Frank, they could create another global crisis.

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