A Discussion on What Led to the 2008 Financial Crisis

The 2008 financial crisis was not caused by one single event. The collapse of the world economy was the culmination of decades of shifts in public policy and financial paradigms like a house rotting at its foundation. Had any of the events or processes leading up to it been different, it is possible that this paper would not need to be written. At its core, however, the crisis brought forth a sobering reality <- one that most people are aware of but choose to ignore anyway, just as the participants in the crisis did: Nobody wins in Vegas, Especially when the charges end up on a credit card.

The conditions that allowed the crisis to occur began to form during the Reagan administration. While Peter Schiff’s mention of the former president in How an Economy Grows and Why It Crashes consists mostly of plaudits for “rolling back some burdensome regulations, and reducing barriers to free trade,” the entire introduction of Too Big To Fail holds Reagan and others accountable for their role in creating the conditions that allowed the crisis to occur.

Reagan’s “Trickle Down Theory” included the relaxation of “burdensome” regulations…but did not do a good job of determining what was and was not “burdensome.” This deregulation-mania continued past the administration of Reagan, until the repeal of Glass-Steagall by the Clinton administration. Glass-Steagall separated investment banks from commercial banks. By the Act, commercial banks were not permitted to make risky investments, and investment banks were forbidden from taking deposits.

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This way, bank runs could be prevented, since the commercial banks that hold demand deposits would be much less likely to find themselves belly-up in defaults and unable to pay their depositors. Without Glass-Steagall, Gordon Gekko can bet on risky securities using the money from George Bailey’s Savings and Loan.

Since large investment banks could now trade on mortgages, they started to securitize them, which allowed them to take advantage of the relative high-yield of mortgages without having to deal with individual borrowers. These new mortgage-backed securities were basically bundles of loans wrapped together, of which investors could buy a slice. The securities were seen as less risky because any bad loans would be balanced out by the abundance of good loans in each package. At first this held true. Since borrowers were originally required to have good credit and to place a hefty down payment on the mortgage, most of the mortgages backing the securities were indeed safe. Over time, however, banks started running out of these high quality mortgages to back the securities they had already loaned out to all of the ideal borrowers.

These banks did what every student desperate to find a prom date does: they lowered their standards, Credit scores required to secure loans dropped, as well as down payment amounts, and interest rates. Adjustable rate loans were offered, which were marketed with very low interest—rates that two years later would jump significantly higher. Lenders started to develop the tactics of a pushy car salesman who is trying to sell an Audi to someone who can only afford a Pinto. These bad, subprime, loans started to overtake the safe loans in the mortgage»backed securities packages. The securities had an inspector, however: the credit ratings agencies. These agencies rate the mortgage-backed securities based on the amount of risk that they carry.

However, these agencies were giving packages of high-risk, almost-guaranteed-to-default, subprime mortgages perfect ratings, which signals that the investment is just as reliable as a Treasury bond. The explanation for this becomes clear if you trace the money Ratings agencies are paid by the lenders packaging mortgage-backed securities. Standard & Poor’s knew that if they gave bad ratings to the mortgage-backed securities from their customers, the banks would walk right down the street to Moody’s to get the ratings that they wanted, and vice versa. In this case, market forces drove the ratings agencies to lower their standards, and put the rubber stamp of approval on whatever junk the banks set in front of them. The kerosene on the flaming financial system were credit default swaps. Banks would ensure themselves against the losses incurred if a mortgage backed security went upside down. The insurer then gets premiums as payment for the risk.

This enabled the banks to move the risk off of their books so that it looked as if all of their investments were safer, so that they could gorge themselves on even more unsafe investments. It is simplest form this was just betting on the bet. Insurance companies operate on the assumption that some of their investments will fail. However, with risk properly managed, they can still retain their solvency as long as the majority of their policies are safe, what happened, however, was that all of the loans defaulted at the same time. When the adjustable rates went up people simply couldn’t pay anymore. AIG had to pay out on all of its policies at the same time, It simply didn’t have the capital to do this. And since AIG insured not only the losses of the banks but also the pensions and financial instruments of average people, the effects of their mismanagement reverberated throughout the entire economy.

They were too big to fail. The primary difference between How an Economv Grows and Why it Crashes and Too Big To Fail is who they choose to blame for the collapse of the economy. How an Economy M blames the overconsumption of spenders, combined with the corruption and ineptitude of the political system when it comes to economic issues. In Too Big to Fail, Dick Fuld uses this logic to rationalize the decisions of the banks by saying “Nobody put a gun to anyone’s head and saying ‘Hey! Nimrod! Buy a home you can’t afford!m While it is true that over consumption and irrational exuberance played a part in the crisis, banks are in the business of risk management. It is theirjob to decide whether or not an investment is safe, both for the borrower and for the lenders Dick Fuld‘s statement is the equivalent of a doctor saying “I know cigarettes are bad for people, but it certainly keeps the cash from these cancer patients rolling in!” It is also clear that the author of How an Economy Grows had an extreme aversion to the measures taken to restore the economy.

Schiff seemed to favor a recovery policy based on austerity. He did not like the Keynesian style recovery methods, such as economic stimulus, applied by the Bush and Obama administrations. The European Union used austerity to try and curb their economic downturn, but it was not effective The United States economic stimulus was necessary to jumpstart the economy. The “worst case scenario” expressed by the book and the film was also fundamentally differentt The biggest fear of Schiff‘s book was that the Chinese would call claim on all of the American debt that they had at once, leading to them taking away all of the material goods in America. The worst case expressed in Too Big To Fail was a sudden lack of credit from the market, making it extremely difficult, if not impossible, to get a loan Schiff’s book barely touched upon the credit crunch that ensued after the crisis, whereas the entire plot of the film was to prevent a second Great Depression caused by lack of credits .

The reason why the measures taken by the Fed and the government during the crisis were warranted was because the cost to the economy of a lack of credit would have been catastrophic to a financial system already on life support. In the film, Ben Bernanke said that “the [Great] Depression may have started because of a stock market crash, but what hit the general economy was a disruption of credit…if we do not act boldly and immediately, we will replay the depression of the 1930s, only this time it will be far, far worse” The bailouts and capital injections by the Fed and the TARP program were necessary, because without it, the financial system would have sunk completely However, they have created a new problem: moral hazard.

The measures to fix the economy were a short term fix, but have created a long term problem. if a parent takes a child to the store, and the child is caught stealing and eating a candy bar from the shelf, then the parent must repay the shopkeeper for the candy. If the parent does not later punish the child for stealing, then the child learns that their parent will bail them out, and he or she will not be averse to stealing again. However, if the child is punished, they learn that stealing is not acceptable. The federal government has just bailed out the banks for stealing. There was no punishment for the banks, and no repercussions for their actions. It is only a matter of time before they do it again.