Financial Crisis of 2008: Trigger, Events, and Resulting Policies

Lead Up and Trigger of Panic After a meteoric rise, housing prices in the United States began to recede from their peak in 2006. There are several factors that led to the housing bubble. An instrumental component was the implementation of collateralized debt obligations, also known as CDOs, in the mortgage supply chain. CDOs, in this context, were backed by the lower and more risky tranches of mortgage-backed securities. These CDOs were then rated higher than the mortgage-backed securities that they were backed by. This “financial alchemy” was justified by the notion that the diversification of mortgages throughout the country lowered risk. High relative returns and solid ratings sent demand skyrocketing for CDOs. Incentives aligned with issuing greater volumes of mortgages rather than focusing on quality. Once mortgages began to default, a vast amount of positions held by various investors, funds, banks, and companies were adversely affected. The ensuing aftermath has been coined as the Financial Crisis of 2008. The months prior to the “trigger” moment of the financial crisis were an uncomfortable time period for the markets but foretold little of what was to come. Prior to the crisis, a few significant events took place. A pivotal moment was when JP Morgan bought out Bear Sterns, a top-flight investment bank, for $10 a share on March 16, 2008 (Financial Crisis Timeline, 2010). Bear Sterns had revealed an 88%, or a $15 billion, drop in liquid assets. The Fed had intervened in this particular case to negotiate a buy out and pledge to fund JP Morgan with up $29 billion in funding for any loss in value of Bear Stern’s assets after the first $1 billion in losses (JP Morgan Announces Amended Merger, 2008). The market was led to believe that any “Too Big to Fail,” defined as a financial

institution that is systemically crucial, firm would be rescued the Fed as per the Bear Stern case (Elliot, 2010). JP Morgan’s acquisition of Bear Sterns was one of the many events to occur in the markets during the following months. On September 15, 2008 Lehman Brothers filed for bankruptcy. This top-flight investment bank had been experiencing financial troubles for months before. Earnings reports prior to the bankruptcy stated that Lehman had lost over $2.8 billion in the second quarter (Financial Crisis Timeline, 2010). The gravity of this bankruptcy was vast and the implications far reaching. Markets worldwide were sent into a downward spiral after the bankruptcy. Though it is difficult to isolate and label a particular event for triggering the financial crisis, there is a considerable amount of backing that the collapse of Lehman Brothers was the trigger of the financial crisis. A survey conducted by SIFMA yielded that over 60% of participants believed the bankruptcy of Lehman Brothers to be the most significant event during the crisis in 2008 (Lehman Brother’s Bankruptcy: Lessons learned from the Survivors, 2009). Lehman had an extensive global footprint in the credit, derivatives, and equity markets. A wide host of institutions and people were subject to the fall out as a result. Over seventy-five separate bankruptcy filings had been filed as a result of Lehman’s insolvency (Lehman Brother’s Bankruptcy: Lessons learned from the Survivors, 2009). The global financial system had been seriously affected by Lehman’s collapse and involvement in the credit and derivatives markets. Prior to Lehman’s collapse the financial markets were still functioning up until the Monday following Lehman’s bankruptcy. On September 15, 2008 markets exploded after news of Lehman going bankrupt. The Dow Jones Industrial average and Standard and Poor 500 both fell 4.4%

and 4.7% respectively in one day (Twin, 2008). Under normal circumstances, the bust of an over-extension of credit results in the retrenchment of credit, defaults on some loans, the potential failure of some financial firms, and a recession. Outstanding Credit Default Swaps had put pressure on firms with exposure to Lehman’s default risk. Large sums of capital were required to compensate counter-parties. The pressure and inability to pay off these debts led to more bankruptcies and created much uncertainty in markets. This unease amongst investors and firms caused large money runs across the globe. Institutions that could have survived otherwise were failing because of the lack of credit. What should have been a boom and bust cycle in the United States turned into a global financial panic the day of Lehman’s bankruptcy.

Main Events of the Crisis Many events followed the collapse of Lehman Brothers. On the very same day, the Bank of America acquires Merrill Lynch and AIG’s credit is downgraded by the three major rating agencies. With news of these events, the markets were shrouded in further uncertainty. Merrill Lynch was another top-flight investment bank. Its sudden acquisition was ill perceived by the market after the fall of Lehman earlier. Much doubt was cast upon financial institutions and their sustainability following the housing bubble burst. The failure and sudden acquisition of two of Wall Street’s most prominent banks ravaged confidence about the future of the financial industry. AIG’s credit rating was downgraded the very same day by all three major rating agencies. The implications of this were that AIG was required to post billions in collateral to its lenders. AIG had already been experiencing trouble in raising capital prior to its downgrading. In addition to its existing lack of capital, AIG was put under tremendous financial pressure once Lehman went

under due to their CDS exposure to Lehman. AIG, one of the biggest CDS writers, had to pay back many counter parties for Lehman’s default. If AIG were not able to pay its counterparties, more institutions would go bankrupt. The RMC money market fund broke the buck following a drop in Lehman’s asset value. RMC had held $785 million debt from Lehman and was forced to write this down to zero. On September 16, 2008, over $28 billion was pulled form the fund and forced the net asset value to drop under the sacred $1 mark (Mackenzie and Davies, 2008). Money markets are assumed to be relatively safe and stable, but RMC breaking the buck shattered confidence in the money markets. By the next day more funds were coming under pressure and money markets, a core component of the financial industry, were freezing up. The effects were evident worldwide because credit flows had practically frozen. In the following month, stock markets across the globe experienced considerable drops value with occasional rises. The turbulent market conditions led to government intervention.

Policy Responses In the United States, government intervention started before the mania had erupted. The Fed, FHFA, and Treasury department were given new authority in regards to the government-sponsored enterprises Fannie Mae and Freddie Mac. Fannie and Freddie were responsible for buying prime mortgages but then got involved in sub-prime mortgages. The US government implicitly backed these GSEs. Once the housing bubble burst, they were unable to execute their task of buying up mortgages effectively. On September 7, 2008. Fannie and Freddie were placed under conservatorship by the

government (Financial Crisis Timeline, 2010). This involved a senior preferred stock purchase from the GSEs. This intervention was conducted with the hopes of stabilizing the housing market and providing security to Fannie and Freddie debt holders. On September 16, 2008 the Fed issued a statement that it would loan AIG $85 billion. The US government issued the loan by buying an 80% stake in the company. It was deemed that AIG was an instrumental player in the financial industry. The Fed went to the aid of AIG a day after watching Lehman go under because an AIG bankruptcy would have created systematic problems. According to the heads of a couple bond investment funds it would have increased borrowing costs and eroded national wealth (Freed, 2008). Lehman was heavily involved in the CDS market but acted as a broker for the most part. AIG was one of the biggest writers of CDS. The effects of its bankruptcy would have spread and caused more bankruptcies and capital concerns for involved parties. Roughly $307 billion out of $447 billion of AIG’s outstanding CDS involved banks in Europe. A potential bankruptcy could have yielded devastating results for the European markets (Freed, 2008). In response to worsening conditions, the Emergency Economic Stabilization Act was passed into law on October 3, 2008 (Troubled Asset Relief Program, 2008). This law established the Office of Financial Stability and authorized the Troubled Asset Relief Program, TARP. This was the first major, non-case by case intervention by the US government. The purpose of the OFS was to manage and distribute the $700 billion dollars of funding from TARP. TARP allowed the Treasury department to buy troubled assets in the form of mortgage backed securities and any other securities the department deemed necessary for bringing and promoting stability in the markets. On October 14,

2008 the Treasury announced that it would be shifting emphasis from buying MBS to a capital purchase program. The Treasury believed that capital injections via warrant and preferred stock purchases from ailing institutions would be the swiftest mechanism for stabilizing the financial markets, encouraging interbank lending, and restoring confidence. Of the funds available, $245 billion have been extended to over 50 institutions across the country (Troubled Asset Relief Program, 2008). Much debate has ensued following the crisis regarding the regulation of banks. Critics of the financial system called for stricter regulation and less systematic risk. The Dodd-Frank Wall Street Regulation Act signed into law on July 21, 2010 is one of the major responses to the call for greater regulation. It is an expansive law that has created regulatory bodies to oversee financial institutions. Dodd-Frank has many provisions. Overall it seeks to protect consumers, ensure stability, increase transparency in the derivatives market, create tools for handling future crises, and tighten regulation for financial institutions and rating agencies (The Dodd-Frank Bill: Too Big not to Fail, 2012). Critics of the bill claim it will smother US financial institutions with so much red tape that the act will do more harm than good. The battle for an efficient balance between regulation and innovation in the financial industry still ensues.

Sources 1. Elliott, Douglas. "Financial Reform: Now It’s Up to the Regulators." The Brookings Institution (2010). 2. Freed, Dan. "AIG Bankruptcy Threat Forced Fed's Hand - TheStreet." Stock Market Today - Financial News, Quotes and Analysis - TheStreet. (accessed June 24, 2012). 3. JP Morgan. "JPMorgan Chase and Bear Stearns Announce Amended Merger Agreement and Agreement for JPMorgan Chase to Purchase 39.5% of Bear Stearns." JP Morgan. Detail_Page_Template&cid=1159339154353&c=JPM_Content_C (accessed June 24, 2012). 4. "Lehman Brother's Bankruptcy: Lessons Learned for the Survivors." Address, Informal Client Presentation from PricewaterhouseCooper, London, August 1, 2009. 5. Mackenzie, Michael, and Paul Davies. "Money markets fund sector shocked." Capital Markets. (accessed June 24, 2012). 6. "The Dodd-Frank act: Too big not to fail | The Economist." The Economist World News, Politics, Economics, Business & Finance. (accessed June 25, 2012). 7. The Economist. "The Dodd-Frank act: Too big not to fail | The Economist." World News, Politics, Economics, Business & Finance. (accessed June 24, 2012). 8. Federal Reserve Bank of St. Louis. "The Financial Crisis Timeline." The Financial Crisis Timeline. (accessed June 24, 2012). 9. Twin, Alexandra. " Market Report - Sep. 15, 2008." CNNMoney. (accessed June 24, 2012). 10. "TROUBLED ASSET RELIEF PROGRAM." United States Government Accountability Office Report (2008): 1-72.

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