What Happened: An inquiry into the 2008 Financial Crisis

Post date: Dec 05, 2019 5:40:12 PM

What Happened: An inquiry into the 2008 Financial Crisis

Growing up in the early 2000s I didn’t understand why money got ‘tight’ in the late 2000s, or why some of my friends were suddenly moving out of the state. I now realize that money was tight and my friends were moving because they were hit by the Great Recession of 2008. In high school I became fascinated by economics and began researching what happened in 2008. The Great Recession of 2008 and my new found fascination of economics leaves me with the following questions to address: Why did the Great Recession happen? Did the recession make the American wealth gap worse? Should we have bailed out financial institutions during the Great Recession, and will there be another recession?

Let’s start this inquiry by asking the most basic question: what is a recession and what is the financial crisis/Great Recession of 2008 and why did it happen? A recession is defined as “a significant decline in general economic activity in a designated region.... Recognized after two consecutive quarters of economic decline, as reflected by GDP” . The Financial crisis of 2008 was a recession which “began in December 2007 and ended in June 2009, which makes it the longest recession since World War II”  

The recession was caused by greedy financial institutions who created a bubble by loaning out money to less than creditworthy borrowers, known as subprime customers. Why would that lead to a financial crisis, why are recessions bad and how do they impact the common person?

Recessions are bad because economic growth slows down, and once economic growth slows down, businesses stop hiring, begin firing and cutting cost in order to stay in business. This was seen in the 2008 Financial Crisis when “monthly job losses averaged close to 750,000” , which lead to “unemployment briefly reach[ing] 10%” At “the lowest point of the Recession- over 230,000 businesses closed” All of those factors created a spiral of more unemployment, since people without jobs could barely afford their necessities, they would spend less on non-essential goods, which led to further job losses as less things were manufactured and sold as a result of the economic crisis. An example of this is that lots of people could no longer afford luxury items such as fancy SUVs and couldn't replace their cars as fast as they would like, so American auto manufacturers such as GM, Ford and Chrysler had a hard time selling cars on their lots, so they had to dramatically cut production of new vehicles and fire employees as a result. 

The crisis was so bad for the auto manufacturers that GM and Chrsler nearly went bankrupt; however, the US Government used the TARP program to bail out these companies: The government’s bailout cost $80.7 Billion and lasted from December 2008 to December 2014 and “taxpayers lost $10.2 Billion” in the bail out, so what caused the recession, and why were corporations bailed out while many Americans suffered and did not receive bailouts or direct help from their government?

The Great Recession was caused by “the collapse of the housing bubble- fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages that was the spark that ignited a string of events which led to a full-blown crisis in the fall of 2008” Simply the “combination of excessive borrowing, risky investments, and lack of transparency put the financial system on a collision course with the crisis” In the case of this crisis, the excessive borrowing was people borrowing lots of money for houses that they could not afford. They were encouraged to do so based on deregulation in the financial sector and predatory financial tools that enabled the borrowing. Some of these products included mortgages where borrowers only paid interest for the first few years of the loan, adjustable rate mortgages where the borrower paid a low introductory rate which would double or even triple after the introductory term. 

Those loans masked the true price of the loan and led many Americans to believe that they could afford a home, even though they were only paying a low introductory and temporary rate, so in reality they could not afford the homes that they bought. In addition to creating the harmful new loan types, the financial institutions loaned out money to people without proper due diligence: these loans were called NINJA loans, which stands for no income, no job, no assets. Those loans are extremely concerning, because people without jobs or the ability to pay them back were loaned lots of money essentially without any expectation of the loans being paid back. Dr. Julie Gonzales a professor of Economics at UC Santa Cruz, remembers the ridiculousness of these loans such as ones where: “you could buy a house without a down payment and only pay the interest on [the loan]... and that’s what drove the bubble which lead to the crash.” Why were the irresponsible loans products such as NINJA loans created?

Irresponsible loans were created because mortgages were seen as loans that would always get paid back, so financial institutions used that idea to create a product called a mortgage-backed security (MBS). An MBS is an investment that bundles up hundreds to thousands of individual mortgages in one investment and it retains its value as home owners continue to pay their mortgages. Banks loved this product, because it allowed them to essentially sell the toxic mortgages that they created to unsuspecting investors who would take the loss if homeowners failed to pay their mortgages. Investors believed that they were making safe investments, since they believed that most people paid their mortgages, so investors and credit ratings agencies all thought that MBS investments were some of the safest investments. 

Those facts lead to an increase in the demand for MBS products so banks loosened their lending standards, created dangerous loans such as NINJA and ARM loans in order to meet the increased demand for MBS investments. Banks were writing toxic mortgages as fast as they could and would then sell them as soon as the next day in a MBS. Since the banks only held the toxic mortgages for a few days or weeks, they did not care about the quality of the loans that they created, because they knew that investors would buy them quickly giving them cheap and quick profits with little risk to them. 

A big problem with MBS investments was that the banks would bundle bad mortgages with good mortgages, so they thought that they made their MBS investments less risky, so they decided to trade their MBS investments with each other and hold lots of them due to their potential for higher profits, so once the housing bubble burst the banks were way too exposed. Large financial institutions such as Lehman Brothers, Bear Stearns, Merrill Lynch and more, either went into bankruptcy, were forced to merge with their healthier competitors, or even taken over by the US Government.

As the crisis worsened, the federal government wanted to reassure citizens that their money was safe in the financial system, so they bailed out every major US bank via stock investments and forced every institution to take the bail out, even if the bank was healthier than its peers. Essentially they forced every large bank to take the bailout funds in order to not expose certain banks who were really struggling , since exposing a bank as one of the failing banks would have led to a panic by the bank’s investors, employees and customers, which would lead to everyone demanding their money back at the same time and that would certainly collapse a bank. This phenomenon is known as a bank run . The government hoped to prevent bank collapses, restore consumer confidence in the financial system and hoped that the new bail out money would be used to create new loans and kickstart the economy. Unfortunately it made the banks bigger than ever and widened the American wealth gap. Should the government have bailed out the banks?

Dr. Gonzales, believes that “the fair thing to do would have been to let the banks collapse and not bail out anyone” Yet she also believes that “the humanitarian thing and the right thing to do was to bail them out, since the collapse of those institutions could have taken out the global economy and financial systems.” She also thinks that the economy would’ve gone into a depression if those institutions weren’t bailed out. A shocking fact about the bailouts is that the US Government earned a $15.3 Billion profit by selling its ownership of bailed out financial institutions in 2014. Even though the government made a profit, the morality and success or failure of the bailouts continues to be argued today, so was the wealth gap widened due to the recession and the bailouts?

Dr. Gonzalez believes that the wealth gap has gotten worse, since “the middle class was not bailed out, and Gen X suffered the most since they had recently bought homes and then lost their homes due to the recession.” The wealth gap essentially got worse because large institutions and their rich investors got bailed out and the value of their assets increased, while the middle class lost jobs, lost their retirement savings, lost their assets and nearly lost faith in the financial system. How is that fair, and what’s the solution to this widening wealth gap?

 Dr. Gonzales believes that the solution is to remove money from politics, raise the estate tax and create a wealth tax in order to shrink the wealth gap. What does removing money from politics mean? Removing money from politics means getting rid of the need for raising campaign funds, since all campaigns would receive money to run from the government, so it would put all politicians on equal financial grounds for every election. The goal would be to encourage new, fresh politicians to emerge and have a fair shot at winning, and raising the estate tax and wealth tax would tax rich people’s assets not their income, so they would pay more in taxes and ideally pay their fair share. So how can we predict the next recession so that we’re better prepared?

Dr. Gonzalez believes that economists sounded the alarm bells leading up the great recession and they were not given as much screen time on cable tv such as other economists who said that the economy was strong, such as the economists from big banks. She believes that the economists from the big banks were influenced to say that all was well, because their banks rely on confidence in the market being high so that people invest more and make more transactions with them, so they have a conflict of interest, while other economists who didn't have a conflict of interest properly raised alarm bells. Her observation is still seen today. When I watch business news like CNBC, I usually hear from the same few economists on their channel. For example I only heard from economists who represented JP Morgan Chase Bank and Bank of America while watching an entire hour of CNBC. Those economists expressed their beliefs that the economy is strong and will continue to be strong for the foreseeable future, sounds very similar to their sentiment before the last recession, so when is the next recession coming?

Dr. Gonzalez believes that the student debt crisis is a significant issue, which could cause the next recession, just as bad mortgage debt caused the Great Recession. Due to the economic similarities of 2007 and the Federal Reserve’s recent actions to stimulate the economy , economists such as Dr. Gonzalez are raising alarms and warning about an imminent recession. She warned that this recession could be worse since the Fed will have fewer tools to deal with the recession because they are stimulating the market while it is supposedly great and thus not needing stimulus, so they are wasting their rainy day tools on days filled with sunshine.  

The Great Recession raised lots of important questions such as why did the recession happen, and should the banks have gotten bailouts? I agree with Dr. Gonzalez that economists see signs of recessions and try their best to warn us, and that the wealth gap needs to be fixed. I personally believe that the banks should not have gotten bailed out, because the working class was not bailed out as well, so the bailouts were not fair and widened the American wealth gap. I also agree with Dr. Gonzalez and other economists who believe that another recession is imminent, while we don’t know exactly when or where the next recession will begin, we are rightfully sounding alarm bells and telling people to prepare themselves for another recession, so are you financially ready to handle an imminent recession?

(Please see the attached PDF for citations, footnotes and other notes)