2008 Financial Crisis

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

© The Balance 2019

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. The crisis led to the Great Recession, where housing prices dropped 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 economic downturn since the Great Depression.
  • The housing market created an asset bubble in 2006.
  • Banks bundled bad home loans with good ones and sold them as mortgage-backed securities.
  • Investors who bought these derivatives believed AIG insurance protected them.
  • Congress bailed out “too big to fail” banks using TARP.

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.

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 to give 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. 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 AIGU.S. Department of the Treasury. “Citizen’s Report. Office of Financial Stability-Troubled Asset Relief Program. Fiscal year 2013,” Accessed Dec. 7, 2019. 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 on Oct.1, 2008, after global stock markets almost collapsed.

Troubled Asset Relief Program

The bailout package never cost taxpayers the full $700 billion. The Treasury disbursed $441.8 billion from the Troubled Asset Relief Program (TARP). By 2018, it had put $442.7 billion back into the fund, making $900 million in profit. It did this by buying shares of the companies it bailed out when prices were low and wisely selling 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. $79.7 billion bailed out auto companies.
  3. $67.8 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 $30.1 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.

Article Sources

  1. U.S. Department of the Treasury. "The Financial Crisis Response In Charts," Page 3. Accessed Dec. 3, 2019.

  2. Federal Reserve History. "The Great Recession," Accessed Dec. 3, 2019.

  3. CoreLogic. "The Comeback Kid: The U.S. Housing Market's Evolution During the Current Economic Expansion," Accessed Dec. 3, 2019.

  4. Government Publishing Office. "Economic Report of the President (2011)," Accessed Dec. 3, 2019.

  5. Bureau of Labor Statistics. "Unemployment in September 2011," Accessed Dec. 3, 2019.

  6. U.S. Department of Housing and Urban Development. "U.S. Housing Market Conditions," Accessed Dec. 3, 2019.

  7. The National Association of Realtors: RealtorMag. "2006 Economic Outlook," Accessed Dec. 3, 2019.

  8. Federal Reserve. "Assessing the Community Reinvestment Act's Role in the Financial Crisis," Accessed Dec. 3, 2019.

  9. Securities and Exchange Commission. "Commodity Futures Modernization Act of 2000," Page 7. Accessed Dec. 3, 2019.

  10. Congressional Research Service. "Who Regulates Whom? An Overview of the U.S. Financial Regulatory Framework," Page 19. Accessed Dec. 3, 2019.

  11. Board of Governors of the Federal Reserve System. "Financial Stability Report – May 2019," Accessed Dec. 3, 2019.

  12. Investor.gov. "Mortgage-Backed Securities and Collateralized Mortgage Obligations," Accessed Dec. 3, 2019.

  13. Federal Deposit Insurance Corporation. "Crisis and Response: An FDIC History, 2008­–2013," Page 5. Accessed Dec. 3, 2019.

  14. Federal Deposit Insurance Corporation. "Crisis and Response: An FDIC History, 2008­–2013," Page 27. Accessed Dec. 3, 2019.

  15. Journal of Economic Perspectives. "Deciphering the Liquidity and Credit Crunch 2007–2008," Page 85. Accessed Dec. 3, 2019.

  16. Journal of Economic Perspectives. "Deciphering the Liquidity and Credit Crunch 2007–2008," Page 87. Accessed Dec. 3, 2019.

  17. Journal of Economic Perspectives. "Deciphering the Liquidity and Credit Crunch 2007–2008," Page 88. Accessed Dec. 3, 2019.

  18. Federal Reserve Bank of New York. "New York Fed Announces Full Repayment of Its Loans to Maiden Lane LLC and Maiden Lane III LLC," Accessed Dec. 3, 2019.

  19. Federal Housing Finance Agency. "History of Fannie Mae and Freddie Mac Conservatorships," Accessed Dec. 3, 2019.

  20. Congressional Budget Office. "The Effects of Increasing Fannie Mae’s and Freddie Mac’s Capital," Page 1. Accessed Dec. 3, 2019.

  21. U.S. Department of the Treasury. “Treasury Department Announces Further Steps to Expedite Wind Down of Fannie Mae and Freddie Mac,” Accessed Nov. 7, 2019.

  22. Board of Governors of the Federal Reserve System. "Federal Reserve Board, with Full Support of the Treasury Department, Authorizes the Federal Reserve Bank of New York to Lend up to $85 Billion to the American International Group (AIG)," Accessed Dec. 3, 2019.

  23. U.S. Department of the Treasury. "Investment in AIG," Accessed Dec. 3, 2019.

  24. U.S. Department of the Treasury. “Citizen’s Report. Office of Financial Stability-Troubled Asset Relief Program. Fiscal year 2013,” Accessed Dec. 7, 2019.

  25. The Federal Reserve Board. "The Cross Section of Money Market Fund Risks and Financial Crises," Accessed Dec. 3, 2019.

  26. Journal of Economic Perspectives. “When Safe Proved Risky: Commercial Paper During the Financial Crisis of 2007–2009,” Page 30. Accessed Dec. 3, 2019.

  27. Congressional Research Service. "Proposal to Allow Treasury to Buy Mortgage-Related Assets to Address Financial Instability," Page 1. Accessed Dec. 3, 2019.

  28. C-SPAN. "First House Vote on Wall Street Bailout (TARP) Failed 205-228," Accessed Dec. 3, 2019.

  29. S&P Dow Jones Indices LLC. "Dow Jones Industrial Average," Download DJIA Daily Performance History. Accessed Feb. 27, 2020.

  30. U.S. Department of the Treasury. “TARP Tracker From November 2008 to January 2020,” Accessed Feb. 27, 2020..

  31. U.S. Department of the Treasury. “Homeowner Affordability and Stability Plan Fact Sheet,” Accessed Dec. 3, 2019.

  32. Brookings Institute. "An Address on Jobs and the Economy by President Barack Obama," Accessed Dec. 3, 2019.

  33. Obama White House Archives. "Remarks by the President and Vice President at Signing of the American Recovery and Reinvestment Act," Accessed Dec. 3, 2019.

  34. Congressional Budget Office. “Estimated Impact of The American Recovery and Reinvestment Act on Employment and Economic Output from October 2011

  35. Congressional Budget Office. "Transitioning to Alternative Structures for Housing Finance: An Update," Page 1. Accessed Dec. 3, 2019.

  36. Congressional Budget Office. "Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market," Page IX. Accessed Dec. 3, 2019.

  37. Consumer Financial Protection Bureau. "What Are Fannie Mae and Freddie Mac?" Accessed Dec. 3, 2019.

  38. U.S. Congress. "Dodd-Frank Wall Street Reform and Consumer Protection Act," Accessed Dec. 3, 2019.

  39. U.S. Government Publishing Office. "Dodd-Frank Wall Street Reform and Consumer Protection Act," Pages 29-32. Accessed Dec. 3, 2019.

  40. U.S. Congress. "Economic Growth, Regulatory Relief, and Consumer Protection Act," Accessed Dec. 3, 2019.

  41. Federal Deposit Insurance Corporation. "FDIC Approves Interagency Final Rule to Simplify and Tailor the 'Volcker Rule,'" Accessed Dec. 3, 2019.

  42. S&P Global. "Ten Years Later, World's Biggest Banks Keep Getting Bigger," Accessed Dec. 4, 2019.