It is said that America was just 8 stock trades away from another Great Depression in September of 2008. If trading had not been stopped, we may have experienced complete financial system failure. Although the previous four years had seen excellent economic growth in America, all of the gains we had worked so hard for seem to slip away as the top five financial institutions either closed, were sold or suffered massive losses. In total 800 banks failed and the world lost twenty-five percent of it's total wealth. What caused America to go from a growing, thriving economy to the Global Economic Meltdown of 2008? Could the government have stopped it before it started and what are we doing to make sure it never happens again?
One of the main factors in the crash was the overselling of sub-prime mortgages and the fall of housing prices. If you own a home, the amount of money you owe to your bank, subtracted from the value, is your equity. Equity rises with housing values and can be borrowed against by the home owner. It appears to make the homeowner owner wealthier, but is not cash. It is the amount the owner would receive if they sold their home. Lots of equity in your house also raises your credit score. As housing prices were rising, the amount of equity was rising. This made people look rich. If you bought a house for 100,000 and after 10 years it was worth 250,000, subtracted the amount of the original loan, you "made" profit. The "wealth" of the homeowner goes up. But only profit on paper, because you never sold the house, so you never had the cash. People's credit scores went up because of the "equity" in their houses and the amount of money the home owner could borrow went up. If the homeowner borrows too much, they go too far into debit. This is can also be called leverage. Also, the company who owns the mortgage shows that the increase in home prices as company profit because the investment is increasing in value. So, the more housing prices rise, the more it looks like people are making money.
Home ownership stopped growing when it reached 65% in the early 1990's. In hopes of allowing more Americans to own homes, and get more buyers into the economy, sub-prime mortgages were introduced. Before this, you had to pass very strict guidelines to be able to get a loan for a house. You had to verify all the required information and have a very high credit score. The most important factor was how long you had worked at your job. These were called conventional loans. They were fairly challenging to get and required a lot of paperwork and time. Only qualified buyers were considered. This left many people to rent houses, they couldn't own a home, which was supposed to be the American dream. Sub-prime mortgages were first introduced in about 1995, to help more people be able to buy houses.
Sub-prime loans are loans with high interest rates for people who would not be able to get a conventional loan. Middle-class families with too much debt, low-income working families who want to buy a home in an expensive housing market and people with very little or no down payment were all perfect for these kind of loans. To cover their risk, lenders charge such borrowers higher interest rates. Adjustable Rate Loans, or ARMs, which offer low interest rates in the beginning, that go much higher after a few years. Introductory rates last two or three years. After that, the rate is adjusted every six to 12 months and can increase by as much as 50 percent or more. Another type of loan that became popular was interest only loans. These loans allowed the borrower to pay back only the interest. With this type of loan, the home owner could even end up owing more money after 10 years because they paid nothing on the house, they only paid interest. In 1990, sub-prime loans were rare. But starting in the mid-1990s, sub-prime lending began surging; taking up 8.6 percent of all mortgages in 2001, soaring to 20.1 percent by 2006. Many of these were called "no-doc" or no documentation loans. This meant people didn't have to prove their incomes and other details, they could just state their income, sign paperwork and borrow up to $480,000.
Another major contributing factor was the lowering of interest rates by Federal Reserve Chairman, Allen Greenspan. The interest rate is the cost of borrowing money and it is set by a government agency called the Federal Reserve. The bursting of the Internet and technology bubble and the Sept. 11 terrorist attacks, lowered the Fed's key rate in 2001 from 6.5 percent to 1.75 percent. Allen Greenspan reduced it more in 2003 to 1 percent, a 45-year low. He left it there for a year before starting to raise it slowly, a quarter-point at a time. Many critics and economists, say rates were too low for too long, causing us to go too far into debit because credit was cheap.
Having more "qualified" buyers and new low rates helped drive up home prices. Many buyers and not enough houses to buy caused prices to rise. This is called supply and demand. The price of an average home nationally rose 160% in 10 years. As housing prices rose, it looked like the net worth of the banks was rising. This created a perception of growth, stocks did well and CEO's made huge bonuses to their salary. The more money people borrowed, the more they spent, this stimulated the economy and led to more jobs and retail sales. In early 2006 everything looked great. As long as housing prices didn't go down, it was fine. But, in early 2006 housing prices dropped 3%. Still, in 2006 lenders made $640 billion in sub-prime loans. Adjustable rate mortgages made up 9% of all home loans. When the time came for rates to adjust, in Spring of 2008, owners began to default. As more owners defaulted, housing prices began to drop. Gas prices went up steeply that summer. Growth in the economy stopped. Unemployment began to rise.
Now, if that was all we had done, we would be in much better shape today. But, it's not that easy. To create even higher growth, new products were invented - new ways to create growth from the original system. The main way this was done was by bundling investments together and selling them in groups. So, mortgages, and other investments and financial instruments, were grouped together and sold in bundles. The problem was 20% of all mortgages were sub-prime, which meant they were risky and people could default. In order to sell the risky investments, an "insurance" called a "swap" was invented and sold along with the investment to cover the risk that it may default. Similar to car insurance, if the car is damaged, the loss is paid back. But, they couldn't call it insurance because insurance is regulated. With insurance the insurer must have funds on hand to be able to pay back a claim. These companies were not required to have the cash to repay claims with, and they were unregulated, meaning the government had no rules about selling them, so they called them Credit Default Swaps.
American companies sold $60 trillion worth of CDS's in the United States and all around the world. As insurance against loss, should loss happen, they would have to be paid. That was why, when we began to loose value in housing, those losses and they had to be paid back. As foreclosures rose 79% from 2006 to 2007, prices fell even more. As prices fell, swaps came due. Major banks and investment companies found that with the devaluing of housing, they owed more money than they had liquid cash. Many institutions just went bankrupt. Most of the largest financial companies had too much of their value in sub-prime backed securities and swaps. They had leveraged too much and owed more money than they had. The top financial firms in the America suffered major losses, many were bought or bailed out by the government. JPMorgan Chase bought Bear Stearns for $2 a share to avoid bankruptcy. Lehmen Brothers filled for bankruptcy. AIG and Fannie Mae and Freddie Mac were bailed out. Losses are spread throughout world economy. In October on 2008, after Lehman Brothers went bankrupt, the stock market dropped 18% over 8 days. American lost an estimated 25% of their wealth and we are still trying to recover.
Considering that the government had to bailout many financial institutions, spending billions, maybe it would have been wiser and cheaper to have prevented the meltdown in the first place. One way the government could try to do that is through regulation. Regulations are rules that American companies have to follow because they have been adopted through legislation. They tell the companies what they can and can't do. Like the rules we have for driving a car. Regulation and the government's ability to enforce it are like the police of the financial world. Many different pieces of legislation had been put in place since the Great Depression to be sure nothing like that happened again. These have been slowly removed over time. The Banking Act of 1933, commonly known as the Glass–Steagall Act, was the law that created the Federal Deposit Insurance Corporation (FDIC) and introduced banking regulations. Some parts of the Act, were removed by the Depository Institutions Deregulation and Monetary Control Act of 1980. In 1999, the Gramm–Leach–Bliley Act repealed a law that prohibited bank holding companies from owning other financial companies. This now allowed commercial lenders such as Citigroup, which was the largest U.S. bank by assets in 1999, to underwrite and trade such as mortgage-backed securities and swaps. Before this they could not participate in those more uncertain markets. Little by little laws that had safeguarded the financial system against failure had been repealed leaving many risky parts of the system un-regulated.
The sub-prime mortgage industry was left mostly un-regulated. The huge agencies Fannie Mae and Freddie Mac, who were partly owned by the government were supposed to provide a kind of regulation. They did not make any home loans, but, they bought half of all the home loans in America. They provided liquid cash into the financial system by buying mortgages from the lenders who wrote them. Established in 1933, they originally only bought loans conformed to high lending standards. In fact, originally the word conforming means conforming to the high standards of these two agencies. But, by 1999, they began to buy sub-prime loans, also. As private lenders started offering new and risky loans, Fannie and Freddie began to lose market share because they had to hold to the Government's higher standards. Between 2004 and 2006, Fannie and Freddie went from holding 48 percent of sub-prime loans to about 24 percent. During this time the un-regulated lending markets created many new kinds of loans to attract homebuyers. Like teaser rates that only lasted a very short while, then the rates shoot up. In 2003, the Bush administration proposed a new agency to oversee Fannie Mae and Freddie Mac. It would be created inside the Treasury Department. They had always been overseen by Committees in Congress. That legislation never passed the Congress. Once the Democrats took control of the House in 2006, new legislation was passed to limit predatory lending practices. No legislation can be found to cover the risky sub-prime market, which seems to be holding the whole thing up. Thousands of people on Wall Street knew the American financial system was built on housing, but no one thought to regulate it or worry that if housing prices dropped the whole thing.
In 2006 the sub-prime housing market had a value of $689 Billion. That sounds like a lot. But it is a very small number compared to the value of all the Credit Default Swap contracts we had sold. That number was $60 trillion. That is the same amount as the world gross domestic product. These were also un-regulated. In fact, they were part of a "private market". There were no regulations in place and none proposed. In fact, in1994, Brooksley Born, the new head of the Commodities Futures Trading Commission, proposed regulation of the credit default market. She warned that if it got too big it could cause a meltdown. The head of the Federal Reserve, Allen Greenspan fought her on the issue and won.. He did not think the market needed regulation. But he ended up being very wrong.
Another instance of bad decision making was the lowering of the net capital rule in 2004. The Securities and Exchange Commission changed the rule only for the top five companies; Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Sterns. The net capital rule sets a limit their debt-to-net capital ratio. Before the change the most they could leverage was 12-to-1, and they had to warn people if they begin approaching this limit, and are forced to stop trading if they exceed it. Under the new change in 2004, they created new computerized models which were supposed to deal with risk and allow more leverage. This allowed the companies to increase their debt-to-net-capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1. Of the five companies that took part in this new plan, three are now bankrupt, and the other two were sold. The normal person in the street likely realizes he can't leverage himself at 40 to 1, weren't banks smarter than the public?
In the year since the collapse of Wall Street, the government has been discussing whether or not to regulate some of these markets. On December 2, 2009, the House of representatives passed a bill that would cover new regulations for these industries, to hopefully avoid having to bailout huge companies like American International Group. This legislation would create an Office of Insurance Information to monitor the insurance industry. It would also give the government the right to stop financial firms from getting so big that they are a risk to the economy, even if they are healthy. Many other bills were introduced over the past year, but failed. Even though they are the minority in both houses of Congress, Republicans have the power to stop legislation to create regulation. Because of the ideas of their party, Republicans oppose regulations of any kind in the financial industries sector. They believe that the industries can regulate themselves, even when it is obvious that is not true. The costs to fix these financial crashes once they have destroyed the world economy, is far too high.
We see a long history of raising the level of leverage in our financial systems, with almost no rules to make sure the money of the American people is safe. As the system took on too much debit, there were no safety nets to make sure the whole thing didn't crash. No one seemed to be paying attention. When asked why no one did anything, one manager said, "Well, it's hard to leave the party when it's in full swing". Up until December of 2007, President George Bush claimed the economy was strong and urged no rules were needed to slow growth. The House of Representatives did just pass sweeping financial reform and regulation. Every Republican voted no. We can only hope that with a Democratic majority in Congress the needed rules will be passed so that America can fully recover from the Meltdown of 2008 and make sure nothing like it happens again.