The 2008 Financial Crisis - Causes and Effects
By Patrick on Sep 29, 2008 in Personal Finance
The 2008 financial crisis is affecting millions of Americans and is one of the hottest topics in the Presidential campaigns. In the last few months we have seen several major financial institutions be absorbed by other financial institutions, receive government bailouts, or outright crash.
So what caused the financial crisis of 2008? This is actually the perfect storm which has been brewing for years now and finally reached its breaking point. Let’s look at it step by step.
Market instability
The recent market instability was caused by many factors, chief among them a dramatic change in the ability to create new lines of credit, which dried up the flow of money and slowed new economic growth and the buying and selling of assets. This hurt individuals, businesses, and financial institutions hard, and many financial institutions were left holding mortgage backed assets that had dropped precipitously in value and weren’t bringing in the amount of money needed to pay for the loans. This dried up their reserve cash and restricted their credit and ability to make new loans.
There were other factors as well, including the cheap credit which made it too easy for people to buy houses or make other investments based on pure speculation. Cheap credit created more money in the system and people wanted to spend that money. Unfortunately, people wanted to buy the same thing, which increased demand and caused inflation. Private equity firms leveraged billions of dollars of debt to purchase companies and created hundreds of billions of dollars in wealth by simply shuffling paper, but not creating anything of value. In more recent months speculation on oil prices and higher unemployment further increased inflation.
How did it get so bad?
Greed. The American economy is built on credit. Credit is a great tool when used wisely. For instance, credit can be used to start or expand a business, which can create jobs. It can also be used to purchase large ticket items such as houses or cars. Again, more jobs are created and people’s needs are satisfied. But in the last decade, credit went unchecked in our country, and it got out of control.
Mortgage brokers, acting only as middle men, determined who got loans, then passed on the responsibility for those loans on to others in the form of mortgage backed assets (after taking a fee for themselves originating the loan). Exotic and risky mortgages became commonplace and the brokers who approved these loans absolved themselves of responsibility by packaging these bad mortgages with other mortgages and reselling them as “investments.”
Thousands of people took out loans larger than they could afford in the hopes that they could either flip the house for profit or refinance later at a lower rate and with more equity in their home - which they would then leverage to purchase another “investment” house.
A lot of people got rich quickly and people wanted more. Before long, all you needed to buy a house was a pulse and your word that you could afford the mortgage. Brokers had no reason not to sell you a home. They made a cut on the sale, then packaged the mortgage with a group of other mortgages and erased all personal responsibility of the loan. But many of these mortgage backed assets were ticking time bombs. And they just went off.
The housing market declined
The housing slump set off a chain reaction in our economy. Individuals and investors could no longer flip their homes for a quick profit, adjustable rates mortgages adjusted skyward and mortgages no longer became affordable for many homeowners, and thousands of mortgages defaulted, leaving investors and financial institutions holding the bag.
This caused massive losses in mortgage backed securities and many banks and investment firms began bleeding money. This also caused a glut of homes on the market which depressed housing prices and slowed the growth of new home building, putting thousands of home builders and laborers out of business. Depressed housing prices caused further complications as it made many homes worth much less than the mortgage value and some owners chose to simply walk away instead of pay their mortgage.
The credit well dried up
These massive losses caused many banks to tighten their lending requirements, but it was already too late for many of them… the damage had already been done. Several banks and financial institutions merged with other institutions or were simply bought out. Others were lucky enough to receive a government bailout and are still functioning. The worst of the lot or the unlucky ones crashed.
The Economic Bailout is designed to increase the flow of credit
Many financial institutions that are saddled with risky mortgage backed securities can no longer afford to extend new credit. Unfortunately, making loans is how banks stay in business. If their current loans are not bringing in a positive cash flow and they cannot loan new money to individuals and businesses, that financial institution is not long for this world - as we have recently seen with the fall of Washington Mutual and other financial institutions.
The idea behind the economic bailout is to buy these risky mortgage backed securities from financial institutions, giving these banks the opportunity to lend more money to individuals and businesses, hopefully spurring on the economy.
What? Credit got us into this mess! Why give more?!?
Ironic isn’t it? Yes, it is true that credit got us into this mess, but it is also true that our economy is incredibly unstable right now, and being that it is built on credit, it needs an influx of cash or it could come crashing down. This is something no one wants to see as it would ripple through our economy and into the world markets in a matter of hours, potentially causing a worldwide meltdown.
As I previously mentioned, credit in and of itself is not a bad thing. Credit promotes growth and jobs. Poor use of credit, however, can be catastrophic, which is what we are on the verge of seeing now. So long as the bailout comes with changes to lending regulations and more oversight of the industry, along with other safeguards to protect taxpayer dollars and prevent thieves from not only getting of the hook, but profiting again, there is potential to stabilize the market, which is what everyone wants. Whether or not it works is to be seen, but as it has already been voted on and passed, we should all hope it does.
Want more opinions? Check out this article on the same topic:
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12 Comment(s)
By ToughMoneyLove on Sep 29, 2008 | Reply
Patrick - I agree with your analysis but you left off one other factor. The government (starting with the Clinton administration) decided in the 1990’s that more folks needed to own their homes, even if they were not financially ready. The government created no-money down initiatives and threatened banks who refused to give credit to these people. As a result, home ownership rates rose 6% to record levels. On top of that, many legislators were bought and sold by money from Fannie Mae and Freddie Mac which were backing these crazy loans.
By Patrick on Sep 29, 2008 | Reply
TML,
That’s a good point, and to be honest, I’ve probably left out several factors - an entire book could be written to cover this financial crisis and I’m sure there are several books already in the making. These problems have been well over a decade in the making.
Ron from The Wisdom Journal recently wrote about the legislators were bought and sold by money from Fannie Mae and Freddie Mac: How Much Did Your Senator or Congressman Take From Fannie Mae or Freddie Mac?. This list also points out how much money each Presidential Candidate received over their tenure in the Senate. It is worth noting.
By Dividend Growth Investor on Sep 29, 2008 | Reply
Patrick,
Thanks for the nice overview. I hope that as a result of the crisis we don’t make the process of purchasing a home too complicated and burdensome.
The main problem is not legislature, its greed. You can’t outlaw it no matter what.
What do you think is the next step in the crisis?
By Patrick on Sep 29, 2008 | Reply
DGI: You’re right, the problem isn’t legislation, although it could be written to simplify the mortgage and lending rules and outlaw some of the forms of loans that are either predatory or irresponsible on the part of the lender (for example, giving mortgages without verifying income).
The next step in the crisis is the bailout which was just agreed upon. We will still see some volatility in the markets, and a few more banks and financial institutions will likely be bought and sold, and possibly even crash. Hopefully the markets will stabilize soon.
By Jarhead on Sep 29, 2008 | Reply
I made some poor financial decisions in the past why isn’t the government bailing out the little guy and not corporate America.
By deepali on Sep 29, 2008 | Reply
I think the problems are much deeper and more troubling. One of the reasons credit was loosened up was to address the growing divide between haves and have-nots. Some people saw injustice in the inability of people of lesser means not being able to access credit. In and of itself, that’s not a problem (loosening credit) - microfinance works incredibly well for the bottom billion, for example. And we also know that how much you make doesn’t say much for how responsible you are with money.
I think the more troubling issue is not greed, but entitlement. Our entire societal perspective on what we are entitled to is all wrong. And I think we see this rebounded in all aspects of our life, not just with credit.
I don’t have a solution, though.
By Until Debt do US part on Sep 29, 2008 | Reply
Good Post.
Too many people got sucked in by the promise of an easy life built on rising home values and easy access to credit. It was like a giant ponzi scheme.
Unfortunately the chickens are now coming home to roost.
By Scott @ The Passive Dad on Oct 1, 2008 | Reply
The teaser rates and HELOC really impacted some of our friends and made it easy to buy a large house with no money down. When any little setback occurs, it can devastate a family and get them late on home payments. I think we might not see 100% or 110% home financing for a very long time. It’s hard to believe people bought homes and also were able to take more money out and buy new cars, boats, and shop for furniture. Kind of like being a kid in a candy store with a free credit card.
By Patrick on Oct 1, 2008 | Reply
Scott, I don’t think we should have seen 100% or 110% loans in the first place. That is irresponsible on the lender’s part and wishful thinking on the borrower’s part.
It looks like the Senate just passed a revised version of the bill. Hopefully it includes some provisions to prevent these mistakes from happening in the future. The next few days will be interesting.
By Stephanie on Oct 9, 2008 | Reply
These are very good points. And yes, Greed was the main issue in this financial crisis we are now going through, BUT the banks AND the government are to blame for. Because the gov’t should control this economy issue AND the banks should not be lending out money when they see that people are not going to be able to pay them back.
By John Goodrich on Oct 11, 2008 | Reply
Your analysis of the current crisis reflects that of most commentators. It is missing three elements.
First, an understatement of real inflation rates (see “core inflation,” the BLS measurement formulae, the “chained” CPI), enabled the Fed to offer credit at terribly low rates, while saying that inflation was contained. (It did not account for the inflation in housing (15-20% per year), fuels (30-50% per year), and used distorted measures for other inflation rates.
Second, this made bankers wildly successful, as banks could take Fed loans at 1% interest and loan those funds to mortgagors at 6%; promptly thereafter selling the loans, and lend to credit card debtors at up to 18% interest (that’s why there was a new credit card in the mail every week).
Third, it created the hedge fund industry, where 10:1 borrowed leveraged was used for commodity investments. As inflation was truly raging, and loans were available at below these inflation rates, hedge fund profits were enormous and almost guaranteed.
These events drove the economy to an explosion of credit.
But it also destroyed savings. No one was going to forego consumption if the rates paid on savings accounts were below the rate of inflation.
As a consequence, other than as a consequence of the inflated assets purchased on credit (e.g., houses), the balance sheets of the citizens quickly deteriorated.
Today we do not have a crisis of liquidity…we’ve had a flood of liquidity. We have a crisis of solvency. People cannot afford to borrow, and banks cannot afford to lend.
There will need to be fewer banks…there’s an easy way to accomplish that…don’t bail them out. There will need to be increased savings, with decreasing consumption. That will be recessionary, and that’s the cost of having gone so far into debt.
You cannot blame greed. People did exactly what government (Fed and fiscal policies) caused them to do. Now, dispite the cost of the cure, government will be unable to fix the problem otherwise. Regrettably it will try. The Paulson plan is a typical mistake. It will weaken citizens’ balance sheets by $700B, and will put this money in places where it actually has no benefit.
Regardless of the heresy involved, the unsuccessful banks need to die. We do not need them, they could not manage themselves, and they will not help us to recover from this.
John B. Goodrich
By Triple Witching on Oct 15, 2008 | Reply
I totally agree with the article above. My article is very similar but far more detailed. Have a read at http://www.triplewitching.com.au. Furthermore, as for there being less banks - well I dont think that is the answer, unless they ‘cant make it on their own’. I do believe the people - the home loan writers need better training and should be given more stringent lending guidleines. After all - we’ve been here before in the 1980s to a lesser degree with regards to copious amounts of debt.