The 2008 Economic Crisis: The Story and the Lesson

In as early as 2000, John Taylor warned law makers of the housing bubble to no avail, until the US economy crashed in 2008. The crisis continued to deepen, reaching its height when the Lehman Brothers filed for the largest bankruptcy in history on15 September 2008, and a full-fledged recession took place.

With time, more banks fell victim to this recession as the fraudulent landing in mortgage finance was done on unrealistic value of houses. A chain reaction of collapses occurred, and institutes ‘too big to fail’ had to be saved by federal action. It was also called a ‘subprime landing crisis’ as commercial and investment banks relaxed lending standards due to limited creditworthy borrowers, and loans and mortgages were advanced to less creditworthy people at higher rates.

As the per capita output in the US fell by over two percent, global recession caused due to interdependence of economies set in. Global Financial Institutions other countries also faced heat as those institutions invested in US subprime Mortgage based Securities (MBS).

As the housing prices fell, foreclosure by lenders led to losses incurred by consumers worth 4.2 trillion in home equity. This happened as the banks had allowed loans worth more than 100% the value of the house.

The analysts who policed mortgage standards faced heavy criticism. Government sponsored analysts such as Fannie Mae, and private scrutinizers were blamed for their mistakes in the expansion of lending and creating the housing bubble, which had let to the crisis.

Others, however, speculate that roots of this financial crisis lies in the affordable housing policies of the US government in 1990’s when government sponsored institutes like Fannie Mac and Freddie Mac’s Federal Agency, to purchase risky loan portfolios. This was done as part of the Community Reinvestment Act (CRA ), which covered housing for the low and middle income groups.

At the time of crisis (in 2008) 50% of loans had some connection with CRA loans. This means that the classification of CRA loans as prime-loans by the Federal Reserve System was incorrect.

The 2008 market crash had many long-lasting and severe impacts.

For instance, at the end of the crisis, housing prices fell by 31.8 percent, and the unemployment rate reached 9 percent. Foreclosure of loans increased by 57%, and the Libor rate reached a record high of 6.9 percent for 24 hours. Practically no inter-bank lending was available. The medium household net worth fell so much, that it is yet to recover to the level of 1998. Dow Jones Industrial Average lost 33.8 percent of its value in 2008, and US imports fell as no credit was being extended for such imports. Japanese export fell by 3.7 % in the second quarter of 2008.

The World Bank’s forecast for global economic growth in 2009 was just 0.9%.

In 2006, while realtors were applauding falling housing prices, the Gramm Rudman act had allowed the trade of derivatives and mortgage based securities accepting home loans as collateral. Even pension funds invested in these derivatives, hoping that the insurance offered under credit default swaps would protect them from any derivative value loss.

In 2008, however, the insurance agency, American International Group (AIG), however, could not honour its commitment, which led to panic and suspicion among banks, which put a stop to their mutual lending, and also had a detrimental effect on their reserves, as companies stopped parking their funds in banks. As a result, global stock markets almost collapsed.

In March 2008, JP Morgan had bought Bear Stearn, which was supported by the Federal guarantee of 30 billion dollars. FRS had to support AIG, and spent 182 billion dollars doing so.

To mitigate the effect of the crisis, the US government and FRS created a bail-out package worth 700 billion dollars. Out of that, 245 billion dollars were spent by the US Treasury to buy bank stocks, which found its way back to the government through the sale of some stocks in 2018. The rest of the money was used by government for a stimulus package.

To such crisis in the future, the US government passed the Dodd-Frank Wall Street Reform Act. This act keeps the banks away from high-risk endeavours, and has reduced the size of banks to prevent them from becoming ‘Too Big to Fail’. Albeit, this act has not yet been implemented, and banks are getting bigger and bigger– one would almost think that no lesson has been learnt from the economic crash 2008.

Note: Last week, Infrastructure Leasing and Financial Services, India’s largest Non-Banking Financial Company (NBFC), defaulted its commitment, which led to the drying up of funds for more than 4500 NBFC’s in India, who collectively had deals worth more than 5 lakh crores. If the practice of defaulting spreads, India too, may have to face a financial crisis.

Picture Credits : US Money Reserve

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