There have been seven sizeable financial crises since the 1980s; the 1987 stock market crash; the savings and loan crisis; Mexican Peso crisis; Asian currency crisis; the collapse of the hedge fund Long Term Capital Management in 1998; the NASDAQ stock bubble; the recent mortgage and the subsequent financial crisis. These repetitive crises indicate the breakdown in the financial system and related regulatory infrastructure that has been much in discussion since the middle of 2008. What leads to financial crises? The reasons include; poor credit evaluation; the probability of extreme events is higher than anticipated or accepted by investors; and firms do not hold enough strong secondary reserves to secure capital adequacy. In essence, too much greed and too little fear leads to financial crises, and too much fear and too little greed sustains financial crises.
As we know and as was reinforced by the events since the middle of 2008, the Federal Reserve’s efforts to successfully implement monetary policies and achieve their goals can be hindered by a set of limitations. The Federal Reserve can lose control of successful outcomes from its monetary policies because it is unable to force banks to lend, people or businesses to borrow, and the public to keep its money in banks. This last point is irrelevant in the United States as we are comfortable with banks. The prior two points, this willingness to lend and borrow is very relevant to the events in 2008 as the credit markets froze, and banks strongly contracted their lending due to distrusting the capacity of borrowers including other banks to pay back the money they have borrowed. This describes a credit crunch. The economy will decline when credit is not flowing. Finally, another constraint of the independent operations of the Federal Reserve and its monetary policies is the globalization of the financial markets as decisions made by investors around the world affect markets around the world, and given that the United States is a debtor nation, this is an important consideration.
Events related to the recent mortgage and the subsequent financial crisis reached their peak starting in September 2008. In September, the Treasury Department took over Fannie Mae and Freddie Mac, the huge government-sponsored mortgage finance firms. Then the Federal Reserve took control of American International Group (AIG) the insurance conglomerate closely allied with securities exposed to the risky mortgages in exchange for $85 billion. Prior to this Bear Stearns failed, and Lehman Brothers disappeared. The Lehman Brothers implosion is blamed for accelerating the crisis. Also, Merrill Lynch was acquired by Bank of America, Goldman Sacks and Morgan Stanley moved to become commercial banks rather than investment banks, and other major adjustments to the U.S. financial markets occurred. These events, as investors in the stock market lost a significant amount of money, were historic. Furthermore, globalization only makes it easier for financial crises to spread. As asset prices in the U.S. fell, the value of capital in highly leveraged institutions fell, the demand for foreign assets fell, and foreign asset prices fell. Then the process starts over again
A primary source of the financial crisis in 2008 was securitization and derivatives. It is important to remember that most mortgages are sold, and then bundled with other mortgages into a package of loans that underlie a bond. This securitization diversifies risk and provides liquidity to the mortgage market. This is positive, but once lenders see that they can off load bad loans into the bond market some will under-value the risk of the loans they make as they focus on their personal gains, and easy credit enticed many borrowers to buy more home then they can afford. Ultimately these securities and derivatives which are essentially a security as well that is invested in portions of other securities, were expected to reduce risk but did not. These securities were excessively complex and did not clearly expose their risk, were exposed to systematic risk, and were sensitive to modeling error.
There were sophisticated investors who anticipated these problems and spoke out about the risk associated with these securities, but they were largely ignored. One was Warren Buffett who in 2003 called derivatives “financial weapons of mass destruction.” Another who warned about this was George Soros. Felix G. Rohatyn, the investment banker who helped New York emerge from its own financial crises in the 1970s, warned of the dangers associated with these securities. On the other hand Alan Greenspan argued that these securities helped spread or diversify risk and enhance safety by facilitating hedging. Others, along with Alan Greenspan argued against regulating the derivatives market and are now also open to criticism.
A measure to address the financial crisis was the Troubled Asset Relief Program (TARP). This was passed by Congress in early October 2008 and it authorized the Treasury Department to undertake a series of initiatives to support the economy. As a result the Treasury Department will be buying troubled mortgage-backed securities; buying mortgages; insuring mortgage-backed securities and mortgages. In addition, the $700 billion bailout bill passed at the beginning of October 2008, gave the Treasury Department the authority to inject cash directly into banks in exchange for an equity stake. By the second week of October the Treasury Department proposed a plan to do just that, to inject cash directly into banks in exchange for an ownership stake. The plan also set limits on executive pay. It is not surprising that this proposal resembled Britain’s plan to nationalize part of the British banking system and guarantee financial transactions between banks, and other plans in the balance of Europe. These plans forced the Treasury Department to adjust its plans, as did the worsening financial crisis, because a more secure European banking system would attract money out of the U.S. banking system weakening the dollar. Furthermore, one example showed that a direct investment of capital for an equity stake can work, and that was in Sweden in the early 1990s. The size of the U.S. investment was initially equal to $250 billion. The purpose of these plans was to attack the problem of uncertainty people have doing business with banks and banks have doing business with each other.
Addressing the mortgage market’s problems directly was proposed as well. It can easily be argued that the financial crisis of 2008 starting with the bursting of the housing market bubble. By October 2008 housing starts were at their lowest level since the early 1980s, millions of homeowners owed more than their homes were worth (I should note that about 85% of homeowners owed less than their homes were worth), and foreclosures were increasing. One proposal offered by R. Glenn Hubbard and Chris Mayer for dealing with this was for the government to refinance mortgages into 30-year fixed rate mortgages at a 5.25% interest rate with less credit worthy borrowers paying more. The purpose of this was to support the housing market and increase home prices, and it can be argued that this would directly address the real underlying problem of the economy, the housing market. This would be relatively easy to do since the government controlled nearly 90% of the mortgage market since the governments “conservatorship” of Fannie Mae and Freddie Mac. This is an example of the importance of the mortgage market to this financial crisis.
There are measures or indices to monitor to assess volatility in the financial markets. These include the CBOE Volatility (VIX) Index (a measure of volatility given by S&P 500 stock index options prices), Libor (London Interbank Offered Rate), the 3-month Treasury Bill rate, and the TED spread. The three-month Libor is a measure of what banks pay each other to borrow for three months, and it rose significantly into the month of October. At the same time as investors poured money into the safest of securities, the 3-month Treasury bill, the rates on these securities periodically plunged to 0.00%, indicating an extreme flight to safety. The TED spread is the difference between what banks pay each other to borrow from each other for 3 months and what the Treasury Department pays and it spiked to over 4.00%, a significant high. Another indicator of risk is the strength of the dollar. Indeed, and perhaps counter-intuitively, the dollar strengthened during this crisis as investors sold commodities and stocks, and bought dollars to buy Treasuries. See related graphs below.
Source: Economic Research, Federal Reserve Bank of St. Louis
Source: Bank of England, Statistics
Source: Chicago Board Options Exchange
Source: Economic Research, Federal Reserve Bank of St. Louis
Source: Yahoo! Finance
