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Financial Crisis: How Did We Get Here?
2008 Financial Crisis: How Did We Get Here?
Financial Crisis, Credit Crunch, Credit Turmoil, Economy in Turmoil, Financial Turmoil, Market Failure, Government Failure, Bank Turmoil, Toxic Securities, Bank Failures, $700 billion Bailout …
These are some of the headlines used to describe the financial crisis we are facing here in the U.S.
The U.S. economic and financial meltdown was triggered by the dramatic failures of such storied US financial institutions as Lehman Bros, Bear Stearns, Merrill Lynch, AIG, Washington Mutual, and the government take over of Fannie Mae and Freddie Mac.
But what really caused this economic and financial meltdown? What led to the failures of these financial institutions? And, how did we get here?
Since this is a presidential election year, there is no shortage of sensational and political reasons being postulated, which often is no more than finger pointing. Here are some of the fundamental reasons that have contributed to this crisis.
Mortgages.
With mortgage interest rates being at historic lows for the past five to ten years, this easy access to credit allowed for an explosion of mortgage originations. These occurred in, not only traditional 30-year fixed loans, but in the more risky sub-prime mortgages and the newly created ARM and option ARM loans.
Many of these newer products, designed with creative features and terms, enabled homeowners with bad credit or no equity to purchase homes they could ill afford. This fueled the demand for homes, which resulted in skyrocketing home values. Rising home values lulled everyone, the homeowners and especially the bankers, into believing these mortgages were safe.
Loan Securitization.
Wall Street financial institutions – Lehman Bros, Bear Stearns, Merrill Lynch, among others – packaged these mortgages in into pools of several hundred million dollars from which mortgage-backed securities were created and sold to investors, often times these firms retaining an interest in these securities. These mortgage-backed securities ironically received the highest possible credit rating (AAA from Standard & Poor's or Aaa from Moody's) at time of issuance, yet their values declined rapidly in a short time thereafter.
Because of the high interest rates on the underlying mortgage loans, many of them being sub-prime loans, Wall Street firms generated enormous profits from these transactions. And, since compensation of Wall Street executives are closely tied to profits, one can easily see the motivation for engaging in these transactions.
Home Values Decline.
With the collapse of the housing market over the past two to three years and the re-setting of interest rates ARM loans, often at significantly higher hates, homeowners could no longer afford these mortgage payments. The result was a dramatic rise in mortgage delinquencies and foreclosures. The consequence is that these mortgage-backed securities began to loose value – rapidly.
Fair Value Accounting.
The complex accounting rule promulgated by the U.S. accounting standard setting board requires companies to account for these mortgage-backed securities at fair value (aka, market value). While this rule worked well in a liquid and stable market where there are ready and willing buyers and sellers, it had the opposite effect in a chaotic and illiquid market. Fair value accounting thus exacerbated and amplified the problem.
So, when one company had to liquidate its portfolio of mortgage-backed securities at low values, it necessitated other companies to value their portfolio at these low values. The result was that those companies no longer had sufficient capital (stockholders’ equity) to remain in business or, in the case of AIG, triggered cross-default contingencies forcing AIG to come up with cash (hence, the need for an $85 billion Federal bailout) to repay its debt obligations. The application of this accounting rule led to a downward spiral in the financial conditions of many of these companies.
Critics have pointed out that a suspension of this accounting rule in these extraordinary times may have avoided some of this problem and, indeed, the accounting board has belatedly issued “clarification” that would permit accountants and auditors to modify their methods for valuing securities in these chaotic times. Meanwhile, the Securities and Exchange Commission, which is the government agency whose mission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation, refrained from suspending the fair value accounting rule even though it has the authority to overide the accounting standard board.
Fannie Mae and Freddie Mac.
Much has been made of Fannie Mae and Freddie Mac, government sponsored entities, being the cause of the financial crisis. While these two companies share some responsibility, the worst of the bad mortgages were originated by mortgage brokers and bought and securitized by Wall Street, bypassing Fannie Mae and Freddie Mac. In September 2008, the U.S. Government stepped in and took control of the two distressed mortgage giants.
Government Regulations or the Lack Thereof.
Many believe this financial crisis stems from a lack of government regulation and oversight of the mortgage industry and Wall Street during the past decade. They point to little government regulation and enforcement to prevent mortgage excesses, for example, zero-down mortgages or, for that matter, origination of fraudulent mortgages. Wall Street was allowed to invent complex derivatives and executives’ compensation was tied to these instruments, with little or no accountability.
These reasons – and there may be many more – are some of the core reasons for this current financial crisis and these extraordinary bank failures. In an attempt to stabilize this financial crisis and the credit system, the government has stepped in with this massive government bailout – to the tune of $700 billion – as well as the direct re-capitalization and nationalization of financial institutions. Worse, the financial crisis in the U.S. has spread worldwide, forcing the major industrialized countries to implement a similar coordinated bailout of their banking and financial institutions. This financial crisis has led to the U.S. Stock Market collapse, the worse since the crash of 1929, with investors loosing several trillion dollars. Foreign stock markets, likewise, are experiencing a similar collapse as the financial crisis spreads globally.
The long-term implication of this global financial crisis and bailout is clearly unknown. Whether these economies can avoid a recession or a worse fate, only time will tell. The free-market laisse fare system, as we once knew it, is clearly undergoing some significant changes, and with a new president to take over in Washington, we can expect more dramatic changes ahead.
The New York Times website article, Credit Crisis — The Essentials, covers the origins of the financial crisis, the failures and seizures of large financial institurions, and the Government’s Bailout Plan.
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Other interesting perspectives:
Wikipedia: Financial crisis of 2007–2009
NYTimes.com: Did Deregulation Cause the Credit Crisis?
Brookings Inst: The Origins of the Financial Crisis
NPR.org: The Origins Of The Financial Crisis - An Interview
Federal Reserve Bank of St. Louis: The Financial Crisis, A Time Line of Events and Policy Actions
Chicago-Kent College of Law: 2008 Financial Crisis Primer
The Baseline Scenario (Blog): Global Crisis Orientation
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