Understanding the 2008 Financial Crisis, part 2

In 2005 and 2006, housing prices began to fall.  This, combined with the fact that the mortgages from 2003 and 2004 were reaching the end of their two-year fixed interest rate and spiking, led to defaults in record numbers.  The fuse had been lit, the dominoes began to fall; use whatever metaphor you want here, it was bad and only going to get worse. 

In March, 2007 Bear Stearns, the 5^th largest investment bank in the country, was unable to meet its financial obligations.  They had invested heavily in mortgage-backed securities and CDOs and had even sold some credit default swaps.  As their shares plummeted, the Treasury Department, led by Treasury Secretary Hank Paulson (the former CEO of Goldmann Sachs), took action to attempt to stabilize the financial sector.  They negotiated a merger in which Bear Stearns was bought by JP Morgan Chase for $2 a share with the government guaranteeing $30 billion in toxic assets. 

The markets stabilized for a time but the underlying problem of housing defaults continued.  The type of large-scale crisis that occurred in September 2008 was the result of these defaults combined with the shady bookkeeping of Wall Street firms.  The actual liquidity of investment banks like Lehman Brothers, financial conglomerates like CitiGroup, and insurance companies like AIG was relatively unknown. 

When Wall Street firms posted almost across the board losses in the 3^rd quarter of 2008 resulting from the investment in mortgage backed securities and CDOs all of the dominoes began to fall.  Lehman Brothers (the 4^th largest investment firm in the country), whose stock had been trading at $66 a share, plummeted to $2 a share in a matter of months (as pictured below).  While Lehman CEO Richard Fuld expected the Treasury Department to give them the same deal they gave Bear Stearns, Secretary Paulson sought a private sector solution (meaning rather than the government guaranteeing Lehman’s toxic assets, the other investment firms would). 

But after the deal with Bank of American fell through (they eventually bought Merrill Lynch) and British regulators killed the deal for Barclays to buy Lehman, Lehman was forced to declare bankruptcy on a Sunday night as an attempt to stabilize the markets opening on Monday.  It did not.  When Lehman declared bankruptcy, British regulations mandated that the personnel at Lehman’s London office leave the premises.  When this occurred, investors who sought to withdraw their money from Lehman’s accounts were not able creating panic and a run not only on that one bank but on every investment bank in the world. 

As a result, the world-wide credit market was frozen; investors could not get their money out of the banks and corporations, such as GE, could not get enough liquid capital to run their day to day operations.  After choosing not to take direct action for the sake of Lehman Brothers, the government realized that they had no other option in this case. 

First, they attempted to steady AIG by buying, originally, $85 billion in toxic assets (that number would later increase to about $160 billion).  When this failed to stabilize the market and various other financial institutions neared collapse the Treasury Department sought Congressional approval for larger-scale action. 

Led by Secretary Paulson and Federal Reserve Chairman Ben Bernanke, they sought $700 billion from Congress for two purposes: continuing to buy the toxic assets poisoning the market and injecting capital into the market to return it from the brink of collapse and unlock the credit market.  While Congress originally voted down the measure (which led to a 777 point drop in the stock market, the largest in history) they eventually agreed to and passed the Troubled Asset Relief Program (TARP). 

So after years of dubious financial management and economic finagling what was the final product?  Millions of Americans defaulted on their mortgages and went into foreclosure; millions of Americans lost their jobs; the American economy lost approximately $1 trillion in value. 

And the Wall Street firms?  Well the investment banks received $125 billion in TARP money which they were supposed to, but did not, lend out; AIG was given a total of $160 billion in taxpayer money to remain solvent; Fannie Mae and Freddie Mac were taken over by the government.  On top of these taxpayer bailouts, the Obama Administration spent almost $900 billion on a stimulus package in an attempt to repair the job market. 

We have learned about the dangers of the specific instruments at play during this crisis; sub-prime mortgages, bad; mortgage backed securities, bad; CDOs, bad; credit default swaps, bad.  But the realities of the financial system have not changed.  The incentive structure remains essentially the same, evident by the record bonuses given out after the financial crisis.  The securitization chain remains in effect for various other financial instruments.  And the government has not instituted any real financial reform; Dodd/Frank was a valiant effort but lacked teeth. 

So now we wait; wait and see if Wall Street has learned its lesson.  I for one would feel better if the future of the American economy was not in the hands of those who most recently brought it to the brink of collapse.