The 2008 financial crisis was the worst economic disaster since the Great Depression of 1929 which occurred despite efforts to prevent the U.S banking system from collapsing. It led to the great recession where housing prices fell 31.8% more than during the depression. Even two years after the recession ended unemployment was still above 9%.
The first signs of the crisis occurred in 2006 when housing prices started to fall. Realtors did not realize that there were too many home owners with questionable credit because banks had allowed people to take loans for 100% or more of the value of their homes. Many blamed the Community Reinvestment Act because it pushed banks to make loans in subprime areas, however this wasn’t the case. The real trouble maker was the Gramm-Rudman Act which allowed banks to engage in trading profitable derivatives that they sold to investors. These required mortgages as collateral and therefore created an insatiable demand for more mortgages.
The Federal Reserve believed that the subprime mortgage crisis would only hurt housing not knowing how far it would spread because it did not understand the true causes of the crisis.
Panic in the Banks
Banks had eliminated the original mortgages and resold the in trenches thus making the derivatives impossible to price. They bought pension funds thinking that credit default swaps would protect them which were sold by an insurance company known as AIG who didn’t have enough cash flow to honor all the swaps. The banks panicked since they could not absorb their losses and stopped lending each other because they didn’t want banks giving worthless mortgages as collateral. This led to rise in inter-banking rates which became the major cause of the financial crisis due to the mistrust amongst banks.
It was over, or was it?
In 2007 the Federal Reserve began liquidating the bank assets through auctions. In March 2008 investors went after investment bank Bear Stearns since they had many toxic assets and wanted JP Morgan Chase to bail him out. Wall Street thought the panic was over but instead the situation deteriorated throughout the summer of 2008.
It was in September 2008 when the crisis created a run on ultra-safe money market funds where companies put excess money that they made so that it could earn some little interest which eventually became treasury bonds worth $140 billion which if they went bankrupt, the economy would come to a halt.