By Hrishikesh Menon. Edited by Arjun Chandrasekar.
The 2008 stock market crash, also known as the Great Recession, was the greatest economic downturn since the Great Depression with $2 trillion erased from the GDP and millions of jobs lost all over the world. We will take a deep dive into this catastrophic event by going into the causes, recovery, and regulatory actions taken to prevent this from happening again.
Sub-prime mortgages and MBS
The problems originated in the housing sector. Interest rates were at historic lows and President Bush had enacted significant tax cuts so a lot of people began buying houses. Normally a potential homeowner looking to get a mortgage has to provide proof that they are capable of taking on a mortgage. This includes verification of applicant employment, income, tax return, credit score, and more. However, in the 2000s, banks were lending high-interest rate mortgages to applicants who have less than average credit. This type of mortgage is called a sub-prime loan and the amount of these getting approved skyrocketed during that time. You might ask yourself, why would banks willingly take on so much risk? They did this because these banks were making boatloads of these mortgages through mortgage-backed securities. These are advanced securities in the form of bonds that only high-net-worth individuals or institutions dabbled in. Going back to the sub-prime loans, these banks would approve these mortgages and sell them to “packaging institutions” which “package” these mortgages into bonds and sell them to investors, who essentially own these mortgages and profit off of the interest payments and home equity, all while the homeowner has no idea of this elaborate process.
Where It Went Wrong
Most of these sub-prime loans were of 30-year maturity so for a long time big investment banks such as Lehman Brothers, Bear Stearns, JP Morgan, Morgan Stanley, AIG, etc, continued to buy a ridiculous amount of mortgage-backed securities as the demand for houses continued to rise until 2007 which is when most of the 30-year sub-prime mortgages were going to reach maturity. Although it was right under their noses, no one on Wall Street or the US government anticipated that a majority of sub-prime borrowers would default on their loans. And so it began: March 16th, 2008, Bear Stearns filed for bankruptcy and narrowly escapes failure by the government agreeing to take on $30 billion of its debt and JP Morgan agreeing to buy the bank out for $2/share. Some may argue Bear Stearns started the crash but it was actually Lehman Brothers which set off the chain reaction. September 15, 2008, Lehman Brothers files for bankruptcy and unlike Bear Stearns, is left to fail. On paper, Lehman had sufficient liquidity but they were unable to sell off most of their assets to raise capital as most of them were worthless mortgage-backed securities, $100 billion worth to be specific. This ignited a huge market-wide panic sell-off causing the Dow Jones to drop approximately 67% before reversing in March 2009. It can be argued that the downturn had begun in September 2007 as between ‘07-’08, the market had shed around 30% but if it weren’t for Lehman’s failure, the market could have reversed a lot sooner.
Bailouts and Regulation
Although lawmakers hated the idea of bailing these banks out, they agreed to pass the Emergency Economic Stabilization Act of 2008 which included the Troubled Asset Relief Program (TARP). This program had a whopping $700 billion for the federal government to buy up illiquid assets in all the big banks. The 6 biggest bank bailouts were: AIG ($180 billion), Citi ($45 billion), JP Morgan & Chase ($25 billion), Wells Fargo ($25 billion), Bank of America ($15 billion), and Morgan Stanley ($10 billion). There were bailouts in the automobile sector, airline sector, and Fannie Mae/Freddie Mac (Mortgage packaging corporations). In total, the 2008 economic bailouts are said to be in the trillions but fortunately, the profit made from this invested capital has paid the taxpayers and government back. Another very important piece of legislation passed in 2010 was the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFWSRCPA). This law extended many existing federal regulations for the financial sector and closed loopholes within the system which allowed this atrocity to happen.
To recap: the 2008 stock market crash was caused by the ridiculous deregulation and everlasting greed of Wall Street. Some keywords are sub-prime loans (high-interest rate loans lent to less than average borrowers) and mortgage-backed security (a derivative bond in which the underlying asset is a pool of mortgages, shares of someone’s mortgage). The market decline began in September 2007 and crashed in September 2008 when Lehman Brothers failed. Big banks such as AIG, JP Morgan, Morgan Stanley, B of A, were bailed out with hundreds of billions. DFWSRCPA of 2010 was passed which increased regulations for the financial sector. Today, the housing and financial sector are secure with the regulations which have been put in place since 2008 but this teaches us a great lesson on the havoc deregulation can wreak on the economy.