By: Octavio Vargas
The economic crisis of 2008 brought the United States into the “great recession” that is still being felt today in 2012. I for one did not fully understand what caused the economic crisis nor did I understand what was happening. Furthermore, when I speak with other students or adults, the vast majority of them also still do not understand how the crisis began or how the crisis unfolded. I decided to read “Too Big to Fail: The inside Story of How Wall Street and Washington Fought to save the Financial System from Crisis--and Themselves” by Andrew Sorkin, to get a better perspective on the economic crisis of 2008.
In President Clinton’s last year in office his administration decided to de-regulate the housing market. What de-regulation of the housing market meant was that traditional banks were no longer the only institutions capable of providing home loans to consumers. Wall Street was able to bundle home loans together which were called mortgage backed securities or collateralized debt obligations. They would then sell slices of the bundles to investors, and began making a lot of money off of the fees charged to investors that in turn made Wall Street ask lenders for more loans.
Lenders normally would only lend money to sound borrowers; for example, a person with at least a 620 credit score and a 20% down payment on their home purchase. After Wall Street began demanding more loans, the lenders began lowering previous lending standards. Lenders would approve loans for people with poorer credit scores and without putting any money down.
The investment banks knew that these mortgage backed securities carried significant risk, so they bought insurance from AIG. The insurance was called a default-swap, meaning that if the consumer defaulted on their mortgage, AIG would pay off the balance. The result of the increased mortgages was a “housing bubble.” The housing bubble was popped when the teaser rates for the majority of consumers ended. A consumer was able to purchase a home at a rate of about 2% interest, but that rate only lasted a few years. The real rate of interest on a mortgage would increase after a couple of years to a rate that the consumer could no longer afford to pay. Consumers began defaulting on their mortgages by the thousands. After consumers began defaulting, AIG was left to pay all the defaulted loans which AIG could not afford to do. If the government had not intervened and “bailed out” AIG, institutions such as Goldman Sachs, Merrill Lynch, JPMorgan, Bank of America, and so on would have recorded massive losses all at the same time. People then would have lost confidence in the banking system and no bank in the world holds enough deposits to satisfy every consumer who decides to take their money out of the bank. Although every bank is FDIC insured, the FDIC does not have enough money to cover a single large bank let alone ten large banks. Also if AIG had failed, many people’s pensions, 401ks and retirement accounts would have been left empty.
The reason why Fannie May and Freddie Mack were controlled by the U.S. Government was because of the large sum of foreign investment and foreign loans that were made into these institutions. The failure of Fannie and Freddie would have significantly decreased the confidence of foreign markets in the United States thus leading to a collapse of the U.S. Economy.
The world economies, as well as the U.S. economy, are economies based on trust. Once the trust is gone, the system fails. What banks allow businesses and people to do is operate. When money is pulled back and credit freezes, then businesses can no longer operate. If banking institutions had not been “saved” there would have been a domino effect that would have destroyed not just the banking industry but all industries.
After reading about the housing collapse in 2008, I wanted to gain a greater knowledge on monetary policy. I went on to read “Inside the Fed: Monetary Policy and Its Management, Martin through Greenspan to Bernanke” by Stephen Axilrod. During the stock market collapse of 1929 monetary policy was not addressed directly. Mr. Axilrod points out that World War II was the cause of forced spending which stimulated the economy out of the depression and recession at that time. The Federal Reserve Act of 1913 was what established the central bank of the United States, and the central bank is one of the tools that the U.S. uses to try and stabilize the economy. In class we learned that we have three major goals in Macroeconomics: Steady growth, Stable prices, and Full employment. We must try to stay consistent on all three goals otherwise the economy begins to get out of control. When we have steady growth the economy is able to produce more jobs. When more people are employed they are able to purchase more items. If prices begin to inflate, the Federal Reserve Banking System can increase interest rates to reduce spending and inflation. If spending begins to stall then the Fed can cut interest rates. The Fed can also buy Treasury securities which increase the money supply in the economy and the Fed can also sell Treasury securities which decrease the money supply. The Fed also decides the level of reserves member banks must hold in their depository.
At times the Federal Reserve cannot stimulate the economy by itself. When interest rates get very low, they become ineffective and then tax cuts and an increase in government spending is needed in order to try to stimulate the economy. The problem arises when the Federal Reserve believes in one policy and Congress believes in another. Mr. Axilrod noted that when the Fed was trying to reduce inflation during the Reagan administration, Congress was proposing tax cuts which would lead to more spending and higher inflation. Axilrod goes on to note that people’s personal agendas can actually hurt the economy at times.