The Financial Crisis of 2008

Terms
Treasury: one of four original cabinet departments. responsible for all federal economic and money issues.

Federal Reserve: bank of the Federal Gov't

Bank, commercial: deposits and loans from businesses

Bank, retail: deposits and loans from consumers

Bank, investment: involved in stock market and can buy shares for itself, including securitized mortgages

Glass-Steagall Act: 1993 Great Depression act that separated commercial and investment banking. Repealed 1999 by bipartisan vote (Senate 90-8; House 362-57) and signed by Clinton

Fannie May Freddie Mac: Federal National Mortgage Assoc. and Federal Home Loan Mortgage Corp. Depression era federal agencies made into a private stock company "backed" by the Federal Gov't. It buys mortgages from primary lenders so that they are "liquid". By 2007, they owned 50% of the $12 trillion market

Mortgage: a type of loan secured by property. Prime mortgage is for those with high credit ratings, good downpayment (>10% of house cost) and good income (monthly payment < 40% of income). All others are "subprime" mortgages. In 1995, 5% of all mortgages were subprime, in 2007, 20

Liquidity: having enough cash on hand to meet expenses

Leverage: the act of borrowing against the money you have as a means of amplifying gains (or, God forbid, losses). Say you use your $1000 to borrow $10,000 (your debt:equity ratio would be 10:1). Say you buy Stock with the $10,000 and it doubles in price, so you sell the stock. YOu pay back the loan ($10,000) and keep the profit ($10,000). You have a profit of 1000%.

Mark to Market: in accounting, how do you value illiquid holdings? One way is to mark to cost (what you bought it for), and it stays on the books at this value until you sell it. In mark to market, you re-value it as you get relevant market information. In a crisis, is the market information accurate? This rule means you can't "wait it out" and therefore the whole industry gets into a continuous down-grading

THE CHRONOLOGY 2002 easy money, with an overly permissive Fed and a global money glut - investors shift to real estate after dot com meltdown - securitization of mortgages; dropping standards for mortgages 2002-2006 real estate values rise rapidly leading to "housing bubble" 2007 real estate values decline; increasing mortgage defaults


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2007, Mar Fed insists on "mark to market" accounting 2008, Mar investment band Bear-Stearns defaults, sold to comm bank Morgan-Stanley with Fed guarantee 2008, July Fannie and Feddie fail 2008, Aug institutional bank credit crisis, no inter-bank lending 2008 Sept investment bank Lehman defaults on loans, Merrill-Lynch sells itself to B of A 2008 Sept largest US insurance company AIG, fails 2008 Sept Reserve Primary Money Market Fund "breaks the buck", crisis deepens 2008 Sept the last 2 investment banks, Goldman-Sachs & Morgan-Stanley agree to become commercial banks

GOVERNMENT BAILOUTS: AN AMERICAN TRADITION

The Panic of 1792: the federal gov't assumed state obligations from the States in 1791, and paid for them with federal bonds that paid 6% (called sixes). When these came under speculative attack, Alexander Hamilton borrowed money from banks to buy the gov't bonds and break the speculators.

The Panic of 1907: this was an era of volatility of which the 1907 bank run was the worst. J. Pierpont Morgan, a New York banking magnate, browbeat all the NY bankers to create a money pool to pay off bank depositors and end the run. Six years later the Federal Reserve was created to serve the same function.

The Great Depression: FDR created an agency to buy the 40% of mortgages that were in default, and re-issue mortgages so that people could keep their homes. When the agency closed in 1951, 80% of loans had been paid off.

Savings and Loan Crisis: in the 1980's, these retail "banks" expanded wildly into commercial real-estate lending after deregulation andpoor regulation. When interest rates rose, half of the 3234 S&L's failed. Congress created the Resolution Trust Corporation to pay depositors andclose out the failures. It ended up costing between $125-200 billion.

THE RUN ON MONEY MARKET FUNDS -MMF's invest in high grade, short term corporate debt. They pay hih\ger interest than banks because they pool depositors' money to buy large blocks of bonds, with higher rates. - they value the shares in the bonds at $1, and interest payout is calculated on that. - it is a large market at $3.4 Trillion, with redemptions of about $7 Billion per week. - on Tuesday, Sept 23, 2008, one of the largest MMFs, Reserve Primay Fund, "broke the buck" on its shares' value when its Lehman bonds became valueless. - withdrawal from all MMF was $79 billion on Wednesday, $49 billion on Thursday. One fund closed its doors. - companies were unable to sell their bonds because the MMF's would not buy as they were raising cash for redemptions - On Friday, the Federal Gov't said it would insure all MMF deposits.

SOLVING THE PROBLEM 1. Overbuilt housing: buy and tear them down 2. Foreclosed mortgages: buy and politicize 3. Securitized Mortgages: buy (?value), and sell in an orderly fashion 4. Failed Investment banks: none left 5. Credit freeze: guarantee deposits, re-capitalize with cash on hand, T-bills and printed money 6. Credit contraction: decrease interest rates versus inflation 7. Economic recession: politics