Financial Crisis of 2008

The Financial Crisis of 2008 is an ongoing financial crisis centered in the United States, with reverberations in Europe and around the world. Losses thus far have run to hundreds of billions of dollars. Owners of stock in major financial institution have lost over 50% of their money, and owners of some have lost 99% as major banks closed down. The stock market has declined 20%-50% in major countries and pension funds have lost value. The price of American houses fell 20%, with much larger declines in California and Florida. However, thus far ordinary depositors with cash in the bank have suffered no losses.

In late September the crisis focused on liquidity--financial companies owned hundreds of billions of dollars of "toxic" securities, mostly based on U.S. mortgages; they could not sell the toxic securities because no one knew how much they were worth, and large scale loans between major institutions stopped flowing as the system lost liquidity and froze up. A $800 billion rescue plan became law in the U.S. October 3, but its impact will not be clear for a while. Meanwhile Europe's economic crisis continues to deteriorate.

Although an American presidential election is in its last month, candidates have not focused on the crisis. Both major parties blame the other for neglecting adequate regulation. Both the major party candidates have expressed anger at the crisis, and have promised extensive new regulations of the financial industry.

Causes

In The Trillion-Dollar Bank Shakedown That Bodes Ill for Cities, Howard Husock describes how the Community Reinvestment Act of 1977 and the expansion in 1995 contributed to the Financial Crisis of 2008.

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 how 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, Morgan Stanley and Goldman Sachs, as well as commercial banking chains like Wachovia and Bank of America, which have thousands of local offices.

Bubble bursts

The housing "bubble" burst in 2006-07, as prices plunged downward in the Sunbelt. Many homeowners could not meet their payments, especially those who had "sub-prime" mortgages because their income was low, or who had adjustable rate mortgages where the monthly payments started small then escalated. Foreclosures skyrocketed. 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 but which glutted the market.

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 will make their scheduled mortgage payments.

2008 crises

Multiple crises started pulling down major financial players. Countrywide, which originated 20% of all American mortgages in 2006, 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. Lehman Brothers, one of the oldest and largest banks in New York, went bankrupt on Sept. 15 with no one to rescue it. Merrill Lynch was sold to Bank of America for $50 billion, about half its value a few months before. Investors realized that AIG could no longer honor the insurance policies it wrote. It lost $13 billion in the first half of 2008 and its shares fell 95% in value. AIG was "too big" to be allowed to fail, so it was given an $85 billion loan from the government; in return the government received 80% of its stock. The government had to add another $38 billion to the AIG rescue in October. 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.

European crises

The crisis affected Britain and other countries as well, as the British housing bubble burst about the same time as the U.S. The British government had to take over major mortgage lenders, including Northern Rock in February, 2008. Northern Rock's loans (£25 billion) and guarantees (£30 billion) extended by the Bank of England, together with the value of the company's mortgages (£55 billion), or £100 billion in all, were added to the British national debt. Bradford & Bingley, half the size of Northern Rock, held £40 billion in toxic mortgages, and was nationalized in late September.

HBOS (Halifax Bank of Scotland) had severe losses and in September was taken over by a bigger bank, the Lloyds TSB Group.

In late September, the Fortis bank, the world's 20th largest business, was partially nationalized by three governments who injected $16 billion in emergency funds. The Belgian, Dutch and Luxembourg governments tried to inject capital but as consumer confidence plunged, Netherlands nationalized the Dutch wing of the company and the rest was sold in early October to the French bank BNP Paribas for €14.5 billion ($19.7 billion). In Germany Hypo Real Estate was given €35 billion ($50 billion) of credit guarantees by the government and other banks. The government of Iceland took over its large banks, as the entire island economy verged on bankruptcy because it depended so much on large foreign loans. Most of the European countries hurriedly announced guarantees of personal bank deposits to avert further drop in consumer confidence and runs on the banks. Stock markets around the world continue to decline as pessimism worsens.

The European Central Bank aggressively lent money to banks trying to ensure that banks would have adequate cash. The moves have not reassured savers or investors, and European stock markets have fallen even further than the American stock markets, as have the stock markets in China and Russia. The leaders of France, Germany and Italy vowed to prevent a Lehman Brothers-style failure in Europe but they did not offer an American-style bailout package.

Britain on October 8 announced a gigantic £500 billion ($850 billion) rescue plan for its banks; the government would partially own them. Prime Minister Gordon Brown said banks would still be run by their old managers, but that the government would have to be "satisfied" on matters of salaries, dividends and lending activities. The money involved is about a third of Britain's annual GDP (comparable to $5 trillion in the U.S. economy.)

$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 major rescue plan--the largest government intervention in the economy since World War II. The key was for the Treasury to purchase $700 billion of the CDOs. The assumption was that the underlying mortgages were mostly perfectly 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, 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. The American Bankers Association and the Mortgage Bankers Association are fighting against any amendment that would reduce mortgage obligations for people in bankruptcy, while directing all the government funds to the banking industry.The U.S. Chamber of Commerce, normally an outspoken advocate of big corporate interests, instead stressed the crisis's impact on small and midsize businesses. "We're looking at an economy that was slipping toward recession even before this crisis culminated in a market lockup last week," said Chamber economist Martin Regalia. The debate in Congress, he said, "is costing every American taxpayer money, directly." 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.

A compromise bailout was agreed to by leaders of both parties but the "Emergency Economic Stabilization Act of 2008" (EESA) was voted down in the House on Sept. 29. Democrats favored the Bush bill 60%-40%, but Republicans voted no by 65-35%. The stock market lost a trillion dollars in value in one day as uncertainty reigned. Finally a large majority passed an expanded bailout bill, that includes the $700 million to buy toxic securities, plus tax breaks and a rise in FDIC insurance to $250,000 from $100,000, designed to reassure ordinary depositors. As the Treasury starts operation of the actual bailout, no one is sure how it will operate or whether it will succeed.

Collapse of #6 and #4 largest banks

O)n Sept. 25, Washington Mutual, the 6th largest bank in the US with $310 billion in assets, went bankrupt after a run in which depositors withdrew $17 billion in a few days. 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.

Meanwhile the #4 U.S. bank, Wachovia, burdened by $120 billion in toxic securities, was bought out by Citigroup on Sept. 29 in a deal engineered by the FDIC. However Wachovia then announced a merger into Wells Fargo, and the matter is in court.

In early October, Bank of America, the new owner of Countrywide, reached a settlement with 11 states that sued it over fraudulent practices. The state of Illinois accused Countrywide of relaxing underwriting standards, structuring loans with risky features, and misleading consumers with hidden fees and fake marketing claims, like a false promise of a "no closing costs loan." Countrywide gave special incentives to its brokers for selling impossible loans by paying higher commissions on them. In reviewing one Illinois mortgage broker’s sales, the Illinois complaint said the "vast majority of the loans had inflated income, almost all without the borrower’s knowledge." Bank of America did not deny the charges and instead agreed to pay out $8.4 billion to 400,000 Countrywide customers. Countrywide will reduce principal balances for some people and cut interest rates for others. Rates for some people could decline to as low as 2.5% and remain at that level for five years. Fannie Mae, Freddie Mac and IndyMac, now all owned by the federal government, have begun their own programs to modify mortgage terms for some hard-pressed borrowers.

See also

Henry M. Paulson