At a recent International Studies Seminar, Professor Donald Frey walked the audience through the entire history of the U.S. financial crisis of 2008. Specifically, his lecture gave the audience a better sense of how events, as far back as the late 1970s, shaped the mentality of those in government to react slowly or poorly to the approaching crisis. In addition, he explained in depth how an unwatched and unregulated system went off the rails much as it did during the Great Depression of the 1920s.
As many of us already know from all of the news coverage, the fiscal crisis that emerged in 2008 was a result of several modes of economic “gambling” taking place simultaneously. First, speculators were taking advantage of uncertainty, betting against the market through short selling. Second, the emergence of hedge fund investments and derivatives contributed significantly, especially absent of any regulation by the federal government. Third, investment bankers invested in major mortgage lenders (including government backed Fannie Mae and Freddie Mac) and their holdings. AIG bet against housing prices falling. This would prove fatal.
In 2006, two factors combined to create the perfect storm of a housing market crash. First, interest rates began to rise for the first time in many years. Second, lenders created new adjustable rate mortgages prior to this time, bringing many new people into debt easier. Now, these same trendy financial vehicles were adjusting upwards. As a result, house payments on these holdings skyrocketed, causing many property owners to default. Starting with this massive nationwide default, ripple effects began to run their course throughout the market.
Mortgage defaults burst the housing market bubble, causing home prices to drop across the country. With a majority of these defaulted mortgages existing on the books of investment bankers, these firms also started to plummet in value. The resulting failures of the big investment firms brought the rest of the market down with them. As a result, bailouts such as TARP, though unpopular, became necessary.
While this was occurring on the surface, Professor Frey also made a convincing argument that the Fed, under Bernanke, was taking extraordinary and unprecedented measures behind the scenes to save the economy. Frey provided an extensive handout packet that included a balance sheet for the Fed. This balance sheet revealed the changes in just three to four short months, including new debts and massive leveraging. Fortunately, Bernanke’s efforts succeeded.
There are several takeaways from the lecture. First, the 2008 financial crisis proves the need for regulation. In the 1980s and early 2000s, many in government took a hands-off approach, thinking that businesses would regulate themselves out of prudence and self-interest. This obviously did not happen. Second, bailouts are nothing new. The 1980s savings and loan bailout is an example. Finally, every financial crisis has a history that extends for years prior to the actual event. In other words, major catastrophes in the market are not spontaneous. They grow over time due to shifting policies and changing technologies.