2008 Financial Crisis: Causes, Costs and Could It Reoccur?

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Bankers who took the bailout
Bankers who are blamed for the financial crisis. (L-R) Goldman Sachs CEO Lloyd Blankfein, JPMorgan Chase CEO Jamie Dimon, Bank of New York Mellon CEO Robert Kelly, Bank of America CEO Ken Lewis and State Street CEO Ronald Logue. Photo: Chip Somodevilla/Getty Images

The 2008 financial crisis was the worst economic disaster since the Great Depression of 1929. It occurred despite aggressive efforts by the Federal Reserve and Treasury Department to prevent the U.S. banking system from collapsing.

It led to the Great Recession. That's when housing prices fell 31.8 percent, more than during the Depression. Two years after the recession ended, unemployment was still above 9 percent.

That's not counting discouraged workers who had given up looking for work. 

Causes

The first sign that the economy was in trouble occurred in 2006. That's when housing prices started to fall. At first, realtors applauded. They thought the overheated housing market would return to a more sustainable level.

Realtors didn't realize there were too many homeowners with questionable credit. Banks had allowed people to take out loans for 100 percent or more of the value of their new homes. Many blamed the Community Reinvestment Act. It pushed banks to make loans in subprime areas, but that wasn't the underlying cause. 

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

The Federal Reserve believed the subprime mortgage crisis would only hurt housing.

It didn't know how far the damage would spread. That's because it didn't understand the true causes of the subprime mortgage crisis until later.

Hedge funds and other financial institutions around the world owned the mortgage-backed securities. The securities were also in mutual funds, corporate assets and pension funds.

The banks had chopped up the original mortgages and resold them in tranches. That made the derivatives impossible to price. 

Why did stodgy pension funds buy such risky assets? They thought an insurance product called credit default swaps protected them. A traditional insurance company known as AIG sold these swaps. When the derivatives lost value, AIG didn't have enough cash flow to honor all the swaps.

Banks panicked when they realized they would have to absorb the losses. They stopped lending to each other. They didn't want other banks giving them worthless mortgages as collateral. No one wanted to get stuck holding the bag.  As a result, interbank borrowing costs (known as LIBOR) rose. This mistrust within the banking community was the primary cause of the 2008 financial crisis

Costs

In 2007, the Federal Reserve began pumping liquidity into the banking system via the Term Auction Facility. Looking back, it's hard to see how they missed the early clues in 2007.

The Fed's actions weren't enough. In March 2008, investors went after investment bank Bear Stearns. Rumors circulated that it had too many of these by-now toxic assets. Bear approached JP Morgan Chase to bail it out. The Fed had to sweeten the deal with a $30 billion guarantee.

 Wall Street thought the panic was over.

Instead, the situation deteriorated throughout the summer of 2008. The Treasury Department was authorized to spend up to $150 billion to subsidize and eventually take over Fannie Mae and Freddie Mac. The Fed used $85 billion to bail out AIG. This later rose to $150 billion.

On September 19, 2008, the crisis created a run on ultra-safe money market funds. That's where most companies put any excess cash they might have accrued by the end of the day. They can earn a little interest on it before they need it again. Banks use those funds to make short-term loans.

Throughout the day, businesses moved a record $140 billion out of their money market accounts into even safer Treasury bonds.  If these accounts went bankrupt, business activities and the economy would grind to a halt.

Treasury Secretary Henry Paulson conferred with Fed Chair Ben Bernanke. They submitted to Congress a $700 billion bailout package. Their fast response reassured businesses to keep their money in the money market accounts.

Republicans blocked the bill for two weeks. They didn't want to bail out banks. They didn't approve the bill until global stock markets almost collapsed. For more details, see 2008 Financial Crisis Timeline.

But the bailout package never really cost the taxpayer the full $700 billion. The Treasury Department only used $350 billion to buy bank and automotive company stocks, when the prices were low. By 2010, banks had paid back $194 billion into the TARP fund. 

The other $350 billion was for President Obama, who never used it. Instead, he launched the $787 billion Economic Stimulus package. That put money directly into the economy instead of the banks. For more, see 2009 Financial Crisis Timeline.

Could It Happen Again?

Many 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. That's because they guarantee 90 percent of all mortgages. Furthermore, securitization (bundling and reselling 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

But it left many of the measures up to federal regulators to sort out the details. Meanwhile, banks keep getting bigger and are pushing to get rid of even this regulation. The financial crisis of 2008 proved that banks cannot regulate themselves. Without government oversight like Dodd-Frank, they could create another global crisis.