Financial Crisis of 2008

The Financial Crisis of 2008 is an ongoing financial crisis centered in the United States, with reverberations in the United Kingdom and other countries. Owners in stock in major financial institution have lost from 50% to 100% of their money, and pension funds have lost value; so far ordinary depositors with cash in the bank have suffered no losses.

Causes

In the early 2000s, U.S. interest rates were low and demand for housing was high, as housing prices soared, especially in California, Florida, Nevada and Arizona. Mortgage companies and banks were very eager to lend at low rates, especially to people with mediocre credit who would not previously have been eligible for mortgages. The expectation was that rising house prices would cover the mortgage payments through refinancing. In addition, hundreds of billions of dollars poured into the U.S. from abroad, and financiers looked for imaginative ways to make a profit. They turned to real estate.

Americans owed some $10 trillion on their mortgages, most of which were sound with payments made on time. However financiers bundled the mortgages into very complicated packages called "collateralized debt obligations' or CDOs. Hundreds of billions of dollars worth of CDO's were sold to banks, pension funds and financiers in the U.S. and Europe. Generally they borrowed cash to buy the CDOs. The risk was that if the CDO's declines in value, they would not be able to repay those loans. To minimize the risk, companies sold insurance called "credit default swaps" (CDS) to guarantee payment of the CDOs. The largest seller was American International Group (AIG), the world's largest insurance company. The CDOs and CDS were especially attractive because they were not regulated by the government; experts are not sure him many trillions of dollars are involved.

Many mortgages were held by mortgage companies like Countrywide and Washington Mutual, as well as investment banks such as Bear Stearns, Merrill Lynch, Lehman Brothers, and Goldman Sachs.

Bubble bursts

The housing "bubble" burst in 2006-07, as prices plunges downward in the Sunbelt, and many people could not meet their payments, especially those who had "sub-prime" mortgages, where the monthly payments started small then escalated. With housing prices falling few people risked buying a new house (because it would soon be worth less than they paid for it). Construction firms had built millions of new houses that could not be sold. Meanwhile foreclosures skyrocketed especially on the loans to people with poor credit.

The problem was that no one could figure out what CDOs were now worth, so very few were willing to buy them. One major investment bank, Merrill Lynch, sold its CDOs for 22 cents on the dollar--a "fire sale" price that was less than they were worth in the long run, because in the long run the great majority of people would make their scheduled mortgage payments.

2008 crises

Multiple crises started pulling down major financial players. Countrywide. the largest mortgage lender, collapsed and was bought up by Bank of America. Bear Stearns, a large investment bank, went under; the government arranged a sale to JPMorgan Chase; stock holders lost about 90% of their investment, and the confidence in other banks was undermined.

On September 7, 2008, the government took control of the two largest mortgage holders, "Fannie Mae" and "Freddy Mac". The two had lost $15 billion ON THE $5.4 trillion in mortgages they owned, and their notes were widely held in China and many other countries. The fear was that if the Treasury did not act the world's confidence in the US financial system would collapse. However the rest of the world was in trouble too. The stock markets in China and Russia plunged 50%, and the British Treasury had to take over its largest mortgage company, Northern Rock. Vast sums of money flowed into the US because it was safer there than anywhere else.

By September the major banks were no longer lending money and most reported huge losses as they wrote down the value of the CDOs and other assets. Short sellers sold large amounts of stock in threatened companies, causing further panic and driving down share prices. In effect AIG, along with Fanny Mae and Freddy Mac were nationalized. The Federal Reserve, with $800 billion in assets, was assisted by the Treasury, which gave it more funds.

$700 billion bailout proposed=

"We're in the midst of a serious financial crisis," President Bush warned the nation on Sept. 25, 2008.:

Major financial institutions have teetered on the edge of collapse, and some have failed. As uncertainty has grown, many banks have restricted lending. Credit markets have frozen. And families and businesses have found it harder to borrow money....without immediate action by Congress, America could slip into a financial panic, and a distressing scenario would unfold: More banks could fail, including some in your community. The stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet. Foreclosures would rise dramatically. And if you own a business or a farm, you would find it harder and more expensive to get credit. More businesses would close their doors, and millions of Americans could lose their jobs. Even if you have good credit history, it would be more difficult for you to get the loans you need to buy a car or send your children to college. And ultimately, our country could experience a long and painful recession.

On September 19, 2008, the Treasury and Federal reserve proposed a rescue plan, whereby they would purchase $700 billion of the CDOs. The assumption was that the underlying mortgages were good in the long run, but that a short-run panic had destroyed the market for them and frozen the financial system. The bailout was needed, President Bush said, to avert a major disaster for the economy. Democrats signed on to the bailout plan, adding provisions for Congressional oversight and caps on CEO compensation; but at the last moment on Sept 25, 2008 House Republicans said no, and GOP presidential nominee John McCain held off endorsement.

Conservatives were split on what to do. Many agreed with Bush that the bailout proposed by Treasury Secretary Henry M. Paulson was urgently needed. Large banks and corporations strongly endorsed the bailout. Democratic nominee Senator Barack Obama endorsed the plan, as amended by Congressional Democrats. On the other hand, ordinary taxpayers and "Main Street", that is businessmen who operated at the local level, were highly suspicious of Wall Street. McCain, blaming the crisis on "the corruption and manipulation of our home mortgage system", rejected the bailout as a favor for Wall Street and little help to Main Street. Believers in the market economy insisted that the market should run its course, and opposed the bailout.

Also on Sept. 25, Washington Mutual, the 6th largest bank in the US with $300 billion in assets, went bankrupt. Its stockholders lost all their money, the US government took it over (through the FDIC, which insures ordinary bank deposits), and resold it the same day to the biggest New York bank, JPMorgan Chase. It was the largest commercial bank failure in American history, by far.

See also

Henry M. Paulson