2008 Financial Crisis: Causes, Aftermath, Investment Lessons

The 2008 Financial Crisis

Causes of the 2008 Financial Crisis

In 2006, for the first time in decades, house prices began to decline. Realtors initially believed that the housing market will return to a more sustainable level following the financial crisis. Too many homeowners with poor credit were granted mortgage loans because of a lack of consideration.

Banks were encouraged to invest in subprime areas because of the Community Reinvestment Act. The Federal Reserve conducted several research and determined that it had little effect on risky lending.

Fannie Mae and Freddie Mac were also blamed by some for the collapse. To them, closing or privatizing the two agencies is the answer. The housing market would implode if they were shut down since they guarantee the vast majority of mortgages.

The Financial Crisis Was Exacerbated By the Deregulation of Financial Derivatives

The financial sector was deregulated by two legislation. They made it possible for banks to invest in housing-related financial instruments. Banks were incentivized to lend to ever-more-risky customers because of these intricate financial products, which were so profitable. The crisis was sparked by this instability.

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When the Gramm-Leach-Bliley Act of 1999 was passed, it authorized banks to invest in derivatives with their customers' money. Bank lobbyists stated they required this move to compete with international corporations and vowed to only invest in low-risk assets to shield their consumers from the possibility of losing money. This pledge was broken as banks raced to cash in on the lucrative derivatives market.

Derivatives were immune from regulation under the Commodity Futures Modernization Act. Also, any state regulations were overruled by it. These complex derivatives could only be handled by large financial institutions.

Mortgage-backed securities (MBS) had the greatest impact on the housing market of any of these instruments. Mortgages based on MBS became more in demand as a result of their increased profitability.

It was hard to price derivatives since the banks had broken up the original mortgages into tranches and sold them to investors.

Mortgage-backed securities were owned by hedge funds and other financial institutions around the world, but they were also found in mutual funds, corporate assets, and pension funds.

Because they thought credit default swaps would protect them, pension funds acquired these hazardous investments. American Insurance Group (AIG) was unable to honor all of the swaps they had offered because of the decline in the value of their derivatives.

Interbank borrowing costs, known as Libor, soared during the financial crisis as banks ceased lending to each other. Although the Federal Reserve began pouring money into the financial sector through the Term Auction Facility, this was not sufficient. It was in 2007, when banks realized they'd have to absorb the losses from their bad loans, that they started to freak out.

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Indicators of Problems

During the summer of 2004, the Federal Reserve began hiking interest rates, and two years later, the Federal funds rate had risen to 5.25 percent. U.S. homeownership peaked in 2004 at 69.5 percent, according to the Bureau of Labor Statistics. Home prices began to plummet in early 2006, causing genuine hardship for many people across the country. Borrowers with low credit scores were forced to take out loans they couldn't afford.

According to the Reuters news service, New Century Financial loaned $60 billion in 2006 to subprime borrowers. In 2007, the company filed for bankruptcy.

Bear Stearns hedge funds were seized by Merrill Lynch when the company halted withdrawals from two of its funds. Subprime lender New Century Financial filed for bankruptcy in April and fired off half of its workers. More than 25 subprime lenders went out of business between February and March of this year.

The Crisis's Price

The graph below shows how much the financial crisis of 2008 cost in total.

Investors sold their shares of investment bank Bear Stearns in March 2008 because it had too many hazardous assets on its balance sheet. As part of the arrangement, JP Morgan Chase was required to guarantee $30 billion for Bear Stearns. Throughout the summer of 2008, Wall Street's predicament worsened.

On September 16, 2008, the Federal Reserve lent AIG $85 billion in a rescue. When the Treasury sold its remaining AIG shares in 2012, the government realized a $22.7 billion profit. Fannie Mae and Freddie Mac were taken over by the Treasury Secretary for $187 billion by Congress at the time. An additional $182 billion was added to the bailout by the Federal Reserve and Treasury.

This led to a rush on money market funds, where businesses deposited surplus cash in order to earn interest overnight, and banks then used those funds to lend short-term. Companies shifted a record $172 billion from money market accounts to even safer Treasury bonds during the run.

Economic activity would have been paralyzed if the nation's money market accounts had collapsed. It was imperative for the government to step in to deal with this problem.

Three days later, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke presented Congress with a $700 billion bailout package. It was their quick response that slowed down the run, but Republicans rejected the plan for two weeks because they didn't want to bail out financial institutions. It wasn't until Oct. 1, 2008, that they passed the law, when the global stock markets were on the verge of collapse.

How Many Banks Failed in the United States in 2008?

According to the Federal Reserve of Cleveland, there were more than 500 bank failures between 2008 and 2015, compared to just 25 in the previous seven years. In most cases, the bank's depositors' accounts were transferred to another bank, along with the bank's assets. Depositors in an American bank never lost a cent because of a bank failure.

Investment banks, rather than regular banks, were the largest losers in the financial crisis. Lehman Brothers and Bear Stearns were two of the most prominent. As a result, Lehman Brothers went out of business. By purchasing Bear Stearns' ruins, JPMorgan Chase saved money.

JPMorgan Chase, Goldman Sachs, Bank of America, and Morgan Stanley, the largest of the big banks, were all " too big to fail," as the saying goes. In spite of the recession, they were able to repay the bailout money and emerge even more prosperous.

Who Profited from the 2008 Crisis?

Before and after the housing bubble burst, John Paulson made a fortune betting against it, and then making a fortune speculating on its recovery. A combination of patriotism and profit motivated Warren Buffett to invest billions in Goldman Sachs and General Electric. Carl Icahn demonstrated his market timing prowess by selling and purchasing casino assets before, during, and after the financial crisis..

In a Nutshell, Here Are the Main Points

When the financial crisis erupted in 2007-2008, it was different. A few others in history have grown large enough to have an impact on the entire economy, but this one was unique. Even those who weren't involved in the mortgage-backed securities market were affected. Because of this, the value of a stock, or any other commodity, can be inflated.

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