How the Financial Crisis Compared to the Depression and Other Crises
Every financial crisis seems to be the worst in history when it occurs. The global financial system is becoming more connected, giving each new financial crisis the potential to be worse than any other. The best way to understand the impact of a financial crisis on the world's economy is to compare the worst crises in history.
Financial Crisis of 2008
At first, it seemed that the financial crisis of 2008 was similar to the Savings and Loan Crisis of 1987. Both were caused by fraud. Mortgage company Ameriquest spent $20 million lobbying legislatures in Georgia, New Jersey, and other states. It sought to relax laws that protected borrowers from taking on mortgages they couldn't afford. Ameriquest was sued for mortgage fraud.
Ameriquest was not alone. Several banks were involved in lobbying efforts. These included Citigroup, Countrywide, and even the Mortgage Bankers Association. Fraud means that mortgage companies were more than just greedy or even negligent, they were unethical.
Both were rooted in bad mortgages. But the subprime mortgage crisis was aggravated by the use of unregulated derivatives. Banks used the value of the mortgages to create a new product called a mortgage-backed security. It sold the derivative to investors. That gave it money to fund new mortgages.
Banks soon found out they could make more money from the derivatives than from the underlying loan. They sold so many derivatives that they needed a constant supply of mortgages. They lowered their lending standards to keep up the supply of mortgages.
All went well until home prices fell. When that happened, the value of the derivatives plummeted. Suddenly, everyone wanted to unload their derivatives. It affected hedge funds, pension funds, and mutual funds. Derivatives turned the subprime crisis into a system-wide financial crisis.
The federal government pumped trillions into the economy to keep the banking system from collapsing. That included the $700 billion bailout package approved by Congress in 2008, the nearly $200 billion the Federal Reserve used to bail out Bear Stearns and AIG, and the $150 billion that the Treasury Department spent to take over Fannie Mae and Freddie Mac.
Long-Term Capital Management Crisis
In 1997, one of the world's largest hedge funds almost collapsed. It had invested in foreign currencies. They plummeted when investors panicked and switched assets to Treasury bonds. LTCM had $126 billion in these assets. Banks bailed it out after Federal Reserve Chairman Alan Greenspan twisted their arms.
Savings and Loan Crisis
In the Savings and Loan Crisis five U.S. Senators, known as the Keating Five, were investigated by the Senate Ethics Committee for improper conduct. They had accepted $1.5 million in campaign contributions from Charles Keating, head of the Lincoln Savings and Loan Association. They had also put pressure on the Federal Home Loan Banking Board, who was investigating possible criminal activities at Lincoln.
In the late 1980s, more than 1,000 banks failed as a result of the Savings and Loan Crisis. The total cost to resolve the crisis was $153 billion, a mere drop in the bucket compared to the 2008 crisis. Of this, the taxpayer was only on the hook for $124 billion. Rather than taking ownership in banks, the funds were used to close them, pay the Federal Deposit Insurance Corporation insurance and pay other debts. Of this, the taxpayer cost was $124 billion.
Great Depression of 1929
Over the four days of the stock market crash of 1929, the stock market dropped 25 percent. During that time, a record $30 billion in market value was lost. That's worth $396 billion today.
In the next ten months, 744 banks failed. As depositors ran to take out their savings, more banks failed. There was no FDIC to bail out deposits. In just three years, $140 billion was lost ($2.3 trillion today).
The stock market crash and banks failures weren't the worst things about the Depression. The Federal Reserve raised interest rates, trying to defend the gold standard. As a result, gold prices soared as investors fled the stock market and depositors traded cash for its value in gold.
By raising interest rates, the Fed slowed the economy. As a result, businesses closed. Unemployment rose to 25 percent, wages dropped 42 percent, and gross domestic product was cut in half. It took ten years and the start of World War II before the economy got back on its feet.