The Financial Meltdown of 2008

In September 2008, a financial crisis started in the U.S. and quickly spread to the world economy. Stock markets dropped disastrously, investment banks failed, and consumer and business credit became very difficult to obtain. For most people, the crisis was sudden and unexpected, and they did not understand what had gone wrong. Here is the story.

The seeds of the 2008 financial meltdown were actually sown back in 2000 when the tech bubble burst and a recession ensued. The Bank of Canada, the U.S. Federal Reserve, and other central banks around the world cut interest rates in an attempt to encourage investment and get their economies moving again. It worked, but the low interest rates caused a boom in real estate values because people could borrow money at very low interest rates. Home mortgages could be obtained with very low interest rates, and many people who had previously not been able to get a mortgage suddenly found that banks were willing to lend them money. Not surprisingly, the increased demand for houses caused home prices to increase.

The increase in housing prices was very pronounced in the U.S. because of the activity of companies like the Federal National Mortgage Association (nicknamed Fannie Mae) and the Federal Home Mortgage Corporation (nicknamed Freddie Mac). Fannie Mae was formed during the great Depression of the 1930s to encourage banks to extend credit to homeowners. It was privatized in 1968. Freddie Mac was formed in 1970 to prevent monopolization in the home mortgage market. As time went on, these two companies (which together guarantee nearly half the mortgages in the U.S.) made increasingly risky loans to homeowners and this added to the problem. (A description of some of the other less well-known players in the mortgage industry is found in Chain of Blame by Paul Muolo.)

Housing prices also increased because investment banks started borrowing money so they could lend it to people who wanted to buy houses. The banks then issued assets (called collateralized debt obligations, or CDOs) to cover their costs. These CDOs were marketed to investors as being very safe because the collateral backing them up was the homes that had been purchased with the money. This would not have been a problem if housing prices had continued to rise, but they didn't, and here's why. The banks made loans with very low "teaser" rates for the first year or two, after which the rate of interest charged increased sharply. Once people got into the third or fourth year of their mortgage, their monthly costs went way up and they realized they couldn't make their payments. So they defaulted on their loans and the banks wound up foreclosing on the home. This caused a drop in demand for homes which, in turn, caused housing prices to drop. As time passed, more and more people got into trouble because many of them owed more on their mortgage than the new (lower) value of their home. Many simply walked away from their homes and stopped making payments.

When housing prices dropped, investment banks had to borrow more money to make up for the reduced value of their CDO assets. But by then investors had become aware of the problems and were reluctant to loan money to anybody. Because banks held so much bad debt, they were also unwilling to loan money (to consumers and to each other), and this caused a liquidity crisis. The London interbank offered rate (Libor) is the rate large banks charge each other when making loans. In early September, the rate went as high as 6 percent, which indicated considerable mistrust between banks.

The crisis was worsened by credit default swaps, which were essentially insurance against defaults on mortgage loans. Ten years ago, CDOs didn't exist, but now the market is estimated at $50 trillion. Let’s say that an investor buys bonds from Corporation X. The investor can buy a credit default swap from Company Y that guarantees that the investor will get his or her money back if Corporation X defaults on its bond payments. The investor pays Company Y a fee (the equivalent of an insurance premium). That kind of insurance sounds like a good idea, but because CDOs were assumed to be very safe investments, very low premiums were charged for credit default swaps. When the housing market went bust, the companies that sold credit default swaps were in big financial trouble. For example, American International Group (AIG) was a big provider of credit default swaps and it charged far too little for them.

Stock markets plunged as the credit crisis worsened. For example, in June 2008, the S&P/TSX index had reached almost 15,000, but during September it dropped to 12,000 and by late October was down to 9,200. This meant huge losses for Canadians who had bought stocks. It was particularly problematic for people who were about to retire because the value of their stocks had declined by as much as 35 percent in just a few weeks. Stock market declines were not limited to Canada and the U.S. Indexes in China, India, and Russia declined by 40-70 percent. By November 2008, most analysts were predicting a deep and lengthy recession for the world economy.

The financial difficulties also caused the bankruptcy of large investment banks like Bear Stearns and Lehman Brothers. Merrill Lynch & Co. was also in trouble, and was taken over by Bank of America. Fannie Mae, Freddie Mac, and AIG were taken over by the U.S. government (total cost: $285 billion). But the bailout of individual companies was not enough. In was becoming apparent that the entire U.S. financial system was getting very close to a complete meltdown. To deal with the crisis, legislators agreed to form a $700 billion bailout fund which gave the U.S. Treasury the authority to buy up so-called "toxic" mortgages and other bad debt that was held by banks. The central governments of Britain, Germany, France, and Italy also developed multi-billion dollar bailout plans. The idea was that if banks around the world were relieved of their bad debts, they would start loaning money again to people who wanted to buy houses, and that would stabilize the housing markets. Loans would also encourage consumers to start buying again, and that demand would create jobs in both goods- and service-producing companies.

One of the provisions in the U.S. bailout plan is a restriction on executive pay. Banks that accept bailout money cannot give departing executives a "golden parachute." This provision is partly a reaction to the outrage that the average person is feeling about the financial crisis. Large salaries for investment bankers and big pensions for bankers who retire are seen as completely unreasonable by middle class citizens because bankers are viewed as one of the key culprits in the financial crisis. To give them million dollar salaries or pensions seems to most people to be completely unreasonable.

Questions for Discussion

1. Who is to blame for the financial meltdown?
2. How is the risk-return principle relevant to the financial meltdown?
3. Why did stock markets around the world decline when the financial crisis occurred?

Sources: Harvey Schachter, "Market Meltdown: The Buck Starts Here," The Globe and Mail, October 15, 2008, p. C2; Tavia Grant, "Bailouts Tied to Curbing Executive Pay," The Globe and Mail, October 15, 2008, p. B4; Marcus Walker, Sara Schaefer-Munoz, and David Gauthier-Villars, "Bailout Price Tags Raise the Question: How?" The Globe and Mail, October 14, 2008, p. B11; Richard Blackwell, "From Subprime to Stock Swoon," The Globe and Mail, October 13, 2008, p. B3; Joel Schlesinger, "A Brief History of a Financial Meltdown," Winnipeg Free Press, October 12, 2008, p. B9; "Wall Street's Rescue," The Globe and Mail, October 6, 2008, p. B4; "Contagion," Winnipeg Free Press, October 3, 2008, p. A15; "Investors Lost Billions, Large Banks and Brokerages Failed, Wall Street's Troubles Went Global," The Globe and Mail, October 1, 2008, p. B1; Janet Whitman, "Scramble to Start Financial Rescue," National Post, September 22, 2008, www.nationalpost.com; Eoin Callan, "Paulson Bailout Extended," National Post, September 22, 2008, www.nationalpost.com; Jeanne Aversa and Julie Davis, "U.S. Puts Taxpayer on Huge Hook," Winnipeg Free Press, September 20, 2008, p. B11; Kristine Owram, "Happy Days Here Again?," Winnipeg Free Press, September 20, 2008, p. B11; Barrie McKenna, "A Desperate Disease, a Desperate Remedy," The Globe and Mail, September 20, 2008, p. B5; Derek DeCloet, "Five Days That Shook the Financial World," The Globe and Mail, September 20, 2008, p. B2; Barrie McKenna, "Fannie, Freddie Stay in Free Fall on Bailout Talk," The Globe and Mail, August 21, 2008, p. B9.

Answers to Questions for Discussion

1. Who is to blame for the financial meltdown?

This question provides a good opportunity to get students to think about where responsibility for the financial meltdown lies. Some of the arguments that will be made during such a discussion are as follows:

In the most general sense, everyone is to blame because they ignored hard economic realities. Greed also influenced decision making. Borrowers are to blame because they took out mortgages on homes that they could not really afford. They were greedy in the sense that they wanted something that they couldn't afford. Mortgage lenders like banks are to blame because they relaxed their lending rules and began approving mortgages for people who couldn’t afford them. They were greedy because they wanted the interest and fees they would receive from the mortgages. They did not give enough thought to whether the people who took out a mortgage could make their payments. Investment bankers are to blame for similar reasons. The fees they collected were very large, and some of their employees made millions of dollars before the system came crashing down. Central bankers around the world are also to blame because they kept interest rates so low for so long and expressed approval of subprime mortgages. In their desire to have strong economic growth, they did not think through the long-term implications of low interest rates.

2. How is the risk-return principle relevant to the financial meltdown?

The risk-return principle says that as risk increases, investors demand higher returns to compensate for the increased risk they are taking. This means, for example, that investors who are very risk-averse are willing to invest in GICs even though they will receive only 3 percent on their investment. They are willing to accept a low rate of return because they know there is virtually no chance they will lose their money. In contrast, investors who are risk-seeking may invest in highly speculative common stock and try for a return of 15 or 20 percent. They know they might lose some or all of their money, but their risk preference is such that they are willing to accept the risk in return for possibly earning a great deal on their investment.

The financial meltdown of 2008 demonstrates the risk-return principle in a unique way. CDOs were marketed to buyers as low-risk investments, but buyers soon discovered to their dismay that they had purchased a high-risk investment. But the basic risk-return principle still holds: the higher the risk that is taken on, the greater the probability that an investment will be lost. The CDOs were actually quite risky because they were based on the assumption that housing prices would continue to rise. When housing prices started to fall, the asset value underlying the CDOs also began to fall, and then real problems began.

Many people would argue that the risk-return principle is violated when governments bailout private-sector companies like AIG, Freddie Mac, and Fannie Mae. The problem with bailouts is that the central government gives billions of dollars to companies to help them out after they have gotten involved in ill-advised, high-risk investments. Much of the unhappiness that has been expressed by the general public is driven by the feeling that the managers who took the big risks are now being bailed out by the government, and the people who will pay the price are taxpayers. But others argue that if the government does not bailout large companies, the effect may be even worse (a large increase in unemployment and perhaps even a depression like the one that started in 1929.)

3. Why did stock markets around the world decline when the financial crisis occurred?

Stock markets declined because investors feared that the financial crisis might trigger a recession. If a recession occurred, business activity in general would decline. That would mean higher unemployment, less money in the hands of people, and reduced demand for the products and services that companies provide. That, in turn, would reduce corporate profits, which would drive down the value of stocks.

Investor emotions were also a factor in causing movements in stock prices. Once stock markets started dropping, fear took over and many investors wanted to get out of the market. So they started selling their stock. But that meant that many more shares were available for sale, so stock prices dropped further.