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Jose Sanchez

Laura Brandenburg

Research Writing

October 29, 2010

The 2008 Financial Crisis

Introduction

The 2008 American financial crisis is more than just a

recession, though this is part of the problem. Recessions,

though never a good thing, are a relatively common, even normal,

part of the business cycle (Moffatt “What”).

The media defines a recession as a decrease in Gross

Domestic Product for two quarters, six months (Moffatt

“Recession“).

Economists prefer to look at

the amount of business activity in the economy by

[examining] things like employment, industrial production,

real income and wholesale-retail sales. [A recession is]

the time when business activity has reached its peak and

starts to fall until the time when business activity

bottoms out. When the business activity starts to rise

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again it is called an expansionary period. (Moffatt

“Recession”)

For most people, in past recessions and in the current

economic crisis, this is just a matter of semantics. Ronald

Reagan put it very well, in a September 1980 campaign speech,

when he said that "Human tragedy, human misery, the crushing of

the human spirit . . . They do not need defining—they need

action" (Ramirez).

The financial crisis of September-November 2008 (or more,

as it was ongoing when this paper was written), the “financial

meltdown,” was the result of more than just normal economic ups

and downs. Oil prices rose greatly, which created economic

pressure, but in the fall of 2008 declined past their starting

point in January 2008. Major casual elements of the crisis

include recklessness on the part of the banking and investment

industry and a combination of negligence and excessive devotion

to free market ideology, on the part of government regulators.

The crisis continued in November 2008 because of the lack

of real progress in improving the economy. Much of this lack of

progress was caused by the complexity of the problems. Problems

that took years to develop could not be solved in days, or

weeks.

World stock markets, particularly in the United States,

will likely be found to have been both a cause and a result of

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the economic crisis of 2008. Current stock markets no longer

even seem to rise or fall in direct response to particular

events (Lepro). Further problems, with the stock market, came

from what is best caused a herd mentality that leads investors

to sell just because others were selling, even if the others

selling are in Japan, Hong Kong and France. The stock market

showed an odd habit of dropping near the end of the trading day,

regardless of any objective events that day. One investment

analyst tried to explain this by saying,

When there is a lot of volatility, especially on a big down

day, people just decide they don't want to own stocks

overnight," said Ryan Detrick, senior technical strategist

at Schaeffer's Investment Research. "News doesn't drive

this lower, fear does. Investors will back the next morning

after they see where things settled. (Lepro para. 11)

The stock market can have psychological effects in addition

to straight economic effects. When the markets drop, people

with investments, regardless of their actual situation, feel

they have less money to spend, or that it is less safe in the

long term to spend money (Lepro). When they spend less,

consumer confidence goes down. Consumer spending makes up 70

percent of the GDP (“Facts on Policy”). When consumers spend

less, the economy drops. It is little wonder that the 1929 –

1941 even to which this crisis is being compared, the Great

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Depression, used the same term used in psychology. Before that

event, what we now call a recession was called a “panic.”

Fannie Mae and Freddie Mac

Two major players in the current financial crisis are the

semi-public organizations known as Fannie Mae (Federal National

Mortgage Association) and Freddie Mac (Federal Home Mortgage

Association). Fannie Mae was actually formed in 1938, during a

later phase of Franklin Delano Roosevelt’s New Deal, as a

government organization, but privatized in 1968. Freddie Mac

was formed as the same type of corporation, private but with

government support, in 1970. Both are designed to provide

support to the private mortgage market, but do not make loans

themselves. In effect, their very existence has created a

secondary mortgage market, where banks and lenders investment in

other banks’ loans.

An additional fact that has to be remembered is that Fannie

Mae and Freddie Mac, by their special status, are not required

to publicly report their financial gains and losses. They are

the only ones of the Fortune 500 not required to file such

reports (Alford).

The Lobbying Power of Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac maintained their position, until

recently, with extensive sophisticated lobbying within Congress

and the executive branch of the Federal government. A study of

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this lobbying effort was published just after their September

2008 bailout and partial takeover by the Federal government.

The investigation was almost certainly underway before, inspired

by reports on of their questionable management and accounting

practices (Chaddock).

As reported in the study

They were the most powerful companies in the country, and

literally controlled the Congress," Peter Wallison, a

senior fellow at the American Enterprise Institute [said].

"Congress would not do anything they did not want Congress

to do – and that came through some very sophisticated

political activities and public relations that made it very

difficult to challenge them. (Chaddock)

Pure cash contribution figures are available for different

time periods. However, they indicate that both companies spent

extensively. Since 1990, Freddie Mac contributed $9.7 million

to Federal campaigns. Since 2004, Fannie Mae contributed $2.9

million. Together they spent $7.4 million in lobby in the first

half of 2008 (Chaddock). This is a period which included both

revelations about questionable accounting, and the mortgage

derivative crisis coming to a head. One would not be too

cynical to wonder if both organizations might have done better,

for themselves and for the country, by spending money to clean

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up their houses – though with the size of the crisis, $7.4

million would not have made much of a difference.

Fannie Mae and Freddie Mac leadership drew from major

political figures. The problem here, aside from the obvious

problems arising from the poor results of their management and

leadership, is that “When you have leaders who are so well

connected and so much of the power structure of Washington, it's

not surprising that people would think that these institutions

were being well looked after by responsible people," according

to a political analyst (Chaddock).

A former congressman, and long time critics of Fannie Mae

and Freddie Mac, has commented that,

‘Everybody knew people with Fannie and Freddie,’ says

former Rep. Jim Leach (R) of Iowa, a longtime critic. ‘More

than any financial institution in America, they were

dependent upon Congress.’

‘If Congress ever changed their charter, it could mean

billions more or less in profit, depending on how the law

is changed. Therefore, Fannie and Freddie had a stable of

lobbyists hired in Washington larger than any stable of

lobbyists of any enterprise in Washington, times three or

four.’ (Chaddock)

Federal Bailouts and Takeovers

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At the time of the Federal bailout and takeover, both

Fannie Mae and Freddie Mac were ordered to cease all political

activities, including lobbying and political contributions.

However, the future of their extensive charitable work, which

also brought them influence in Congress, remains uncertain

(Chaddock).

Similar Federal aid, in some form, was extended to AIG

Insurance a week or so later. AIG has since been in the news

when, at least twice, senior executives held meetings at

expensive resorts. Lehman Brothers, a week after the Fannie and

Freddie take over, was denied such Federal assistance and filed

for bankruptcy. The Federal reasoning was that Lehman had too

many bad assets to make a take over possible. J. P. Morgan, not

along after, provided the broker-deal unit of Lehman $138

billion to, basically, settle pending business.

The most controversial Federal bailout was a general

package proposed in September 2008. The plan, costing over $750

billion, was rejected by the House of Representatives on

September 29, 2008, despite its heavy support by President Bush.

This caused the Dow Jones to decline over 777 points, the worst

decline ever. An adjusted version of the bill passed the Senate

a few days later. After passage in the House it became law on

October 3, 2008. No one seemed to really like the bill. But the
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supporters recognized the dangers of letting the American

financial system collapse.

Derivatives and SubPrime Mortgages

The main cause of the current worldwide economic crisis is

the housing mortgage industry, in particular a form of

investment known as “mortgage backed securities,” a type of

financial instrument known as the “derivative.” Derivatives are

financial instruments whose value depends on an underlying asset

(Weinberg). Derivative securities as investments also depend on

the stability and security of the underlying assets backing the

derivative. In this case the underlying assets are subprime

mortgages.

A Forbes investment website defines a subprime mortgage as

a type of loan granted to individuals with poor credit

histories . . .who, as a result of their deficient credit

ratings, would not be able to qualify for conventional

mortgages. Because subprime borrowers present a higher risk

for lenders, subprime mortgages charge interest rates above

the prime lending rate. (“What Is a Subprime Mortgage?”)

It is an interesting irony that “subprime” is used in its

more standard meaning as below normal, rather than to refer to

an interest rate below prime.

The most common type of subprime mortgage has been the

Adjustable Rate Mortgage, ARM. Interest rates start low and

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then rise. Borrowers had found subprime mortgages easier to

obtain between 2004 and 2006, due to low interest rates, the

increased availability of money to lend, and the increased

willingness of banks to lend money. The Federal Reserve Board

had been keeping interest rates relatively low, which stimulated

borrowing and lending.

The Federal government was also encouraging, and forcing,

lenders to lend to lower income communities (Brook), with little

indication of any control over the lending. Use of money for a

good cause, in the national interest, became reckless

distribution of money, definitely not in the national interest.

One can also wonder why the government did not realize that a

legitimate direct use of government money is to improve living

conditions for people. No one has really explained why

investment in low income neighborhoods was not done directly; or

at least with more careful government control.

ARM rates went up more than many people expected. Lenders

wanted to charge higher rates to compensate them for increased

risk. They clearly did not consider that they were increasing

the very risk they feared. The number of people forced to

default on these loans, and facing foreclosure, substantially

increased. Lenders who made these loans directly, or who joined

in the process through derivatives, experienced extreme

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financial problems, including bankruptcy (“What Is a Subprime

Mortgage?”)

The damage to major investment banks was severe. Some

major banks, such as Lehman Brothers and Bear Stearns, went out

of business. Fannie Mae and Freddie Mac lost almost $100

billion in stockholder share value in 2008 alone, as of the end

of August 2008. Stock price for both was down about 85%

(Bogoslaw).

Overreaction to the overextending of credit led to a

substantial and equally damaging tightening of credit. Credit

almost briefly disappeared. The results in the economy and

American and world stock markets in the fall of 2008 were

drastic.

Warning Signs

Looking back at how the crisis of 2008 began, one cannot

help wondering how and why it was allowed to happen. Warnings

signs about derivatives and subprime mortgages were available

several years before 2008. In the Berkshire Hathaway Annual

Report for 2002, noted investor Warren Buffett, one of the

richest and most successful men in the world, described

derivatives as “time bombs, both for the parties that deal in

them and the economic system” and announced that his company was

getting out of derivatives (Berkshire Hathaway 13).

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About the same time, in an attempt to justify the need for

limited or no Federal government regulation of derivatives, then

Chairman of the Federal Reserve Board Alan Greenspan, stated

that,

Although the benefits and costs of derivatives remain the

subject of spirited debate, the performance of the economy

and the financial system in recent years suggests that

those benefits have materially exceeded the costs.

Except where market discipline is undermined by moral

hazard, owing, for example, to federal guarantees of

private debt, private regulation generally is far better at

constraining excessive risk-taking than is government

regulation. (Weinberg)

Greenspan has been a major proponent of deregulation. He

also was the leading proponent, through the Federal Reserve

Board’s power to set interest rates, of lower rates. Greenspan

testified before the United States House of Representatives,

Committee on Oversight and Government Reform, in late October

2008 that

. . . those of us who looked to the self-interest if

lending institutions to protect shareholder’s [sic] equity

(myself included) are in a state of shocked disbelief. Such

counterparty surveillance is a central pillar of our

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financial markets’ state of balance. If it fails, as

occurred this year, financial stability is undermined. (2)

Conclusions

As quoted above, Alan Greenspan recently stated that,

. . . those of us who looked to the self-interest if

lending institutions to protect shareholder’s [sic] equity

(myself included) are in a state of shocked disbelief. Such

counterparty survellience is a central pillar of our

financial markets’ state of balance. If it fails, as

occurred this year, financial stability is undermined. (2)

Greenspan accurately gave reasons for the current crisis,

why a possibly inevitable economic slowdown has been described

as the worst crisis since the Great Depression of the 1930s.

The financial industry saw a way to make a lot of money, using

great availability of credit to lend money to people who might

otherwise not be able to get loans to buy houses.

Increasing the number of families who own home is in

keeping with the proverbial American dream. But they forgot

that part of the American dream is earning one’s own way.

Helping neighbors who need help is also in keeping with American

traditions, but long term help is supposed to go where it can do

the most good. And it is supposed to be real, and accomplish

something, not set people up, however well meaning the help, for

more drastic future failure.

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Investing in home mortgage loans, through derivatives, was

in keeping with the general bank practice of sharing the risk by

trading or selling loans. Investments can rarely be guaranteed.

However, there is a concept called “due diligence.” Investors

are supposed to check on the reasonable safety of the risk they

are taking. Mortgage lenders, and derivative buyers, including

Fannie Mae and Freddie Mac, did not perform due diligence.

Housing is a proper area of government interest, and for

this reason alone the Federal government should have become

involved. If the Federal government did not want to directly

invest, it should have paid more attention to the investments

that were being made. The Federal government should have

noticed the increase in potentially risky loans. If these loans

were felt to be in the national interest, the government at

least would have been prepared for increased loan defaults.

When a second step was added, through derivatives, the

Federal government should have realized the potential negative

multiplier effect of defaults if people could not meet their

mortgages. Greenspan held an office, Chairman of the Federal

Reserve Board, where he particularly should have realized the

potential problems.

But Alan Greenspan, who was by no means alone, was too

strong an advocate of deregulation. He represented the

ideological view that failed to realize that a totally

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unrestrained free market runs the risk of recklessness, and that

it can be as bad as a totally controlled market. This view

allowed Fannie Mae and Freddie Mac to operate as loose cannon

hybrids, neither fully private sector nor fully government

agencies. Greenspan, in October 2008 became on the few public

officials to admit error. Mistakes are not made. People make

mistakes.

The general Federal bailout to the financial industry,

passed at the end of September 2008, was very controversial.

Arguments against the bailout were valid, stating that part of

the free market is the ability to fail and go out of business.

Companies should not be rewarded for poor management, poor

judgment or out and out greed. Arguments in favor tended to

admit that argument as being true, but that the rippling damage

from further financial institutional failures would be far

worse.

The government had to be seen to be doing something. One

hopes the government will take correct action, but the action

itself is often sufficient. Franklin Delano Roosevelt

recognized this truth, as far back as 1933. Herbert Hoover, his

predecessor, had responded to the Great Depression by doing

nothing. When unemployed World War One veterans camped in the

outskirts of Washington, D.C., Hoover sent army troops to remove

them. Roosevelt tried to show the American people that he cared

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about them, and that his administration was acting to solve the

economic crisis. He also tried to show the people that he cared

what they think, and that he recognized the need to “sell” his

programs and policies to the American voters.

President Ronald Reagan was called the “great

communicator,” because of his ability to talk directly to the

American people to win support for his programs, and because he

realized the value of doing going to the people. Roosevelt was

the first great communicator. He held his first “fireside

chats” over national radio on March 12, 1933. Roosevelt used

simple language to explain the banking bill. He assured the

American people that it was "safer to keep your money in a

reopened bank than under your mattress" (Roosevelt 64).

Roosevelt continued to effectively use radio throughout his

administration.

The Bush Administration in its remaining months, and the

Obama administration, have to be shown to be acting in order to

restore confidence in the American and world economic systems.

The government has to be shown to be doing something, to

restore confidence in the system. The government has to judge

policies on what is likely to work, in the short and the long

term, not based on the ideology. Ideology has not worked in the

past, most damagingly the lax financial regulations of the past

few years. The October and November volatility in the stock

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markets, with the slow implementation of the Federal bailout

package, as well as general lack of investor confidence, showed

that those favoring the plan had at least this fact correct.

If there is a lesson to this whole crisis, it is that

government regulations and controls are most effective as a last

resort. Free market advocates have this right. However, the

major financial sector error of the past few years is forgetting

that government controls and regulations have a purpose, if only

as a threat to combine with incentives as the best way to ensure

good behavior. Government controls may not have to be used.

But they have to remain ready and be seen to remain available.

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Works Cited

Alford, Rob. “What Are the Origins of Freddie Mac and Fannie

Mae?” History News Network. 2003 and 2008. George Mason

U. 17 Nov. 2008 <http://hnn.us/articles/1849.html>.

Berkshire Hathaway 2002 Annual Report. 2003. 16 Nov. 2008

<http://www.berkshirehathaway.com/2002ar/2002ar.pdf>.

Bogoslaw, David. “Fannie Mae and Freddie Mac: A Damage Report.”

29 Aug. 2008. Business Week. 17 Nov. 2008

<http://www.businessweek.com/investor/content/aug2008/pi200

80828_330540.htm>.

Brook, Yaron. “The Government Did It.” Forbes. 18 July 2008. 17

Nov. 2008 <http://www.forbes.com/2008/07/18/fannie-freddie-

regulation-oped-cx_yb_0718brook_print.html>.

Chaddock, Gail Russell. “Fannie Mae, Freddie Mac wielded big

clout in Washington.” 12 Sept. 2008 Christian Science

Monitor. 17 Nov. 2008

<http://www.csmonitor.com/2008/0912/p03s01-usec.html>.

“Facts on Policy: Consumer Spending.” Hoover Institution. 19

Dec. 2006. 16 Nov. 2008

<http://www.hoover.org/research/factsonpolicy/facts/4931661

.html>.

Greenspan, Alan. “Alan Greenspan, Committee on Government

Oversight and Reform.” 23 Oct. 2008. 16 Nov. 2008

<http://oversight.house.gov/documents/20081023100438.pdf>.
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Lepro, Sara. “Stocks Skid on News Gov’t Won’t Buy Banks’

Assets.” Yahoo! News. 12 Nov. 2008. Yahoo! 12 Nov. 2008

<http://news.yahoo.com/s/ap/20081112/ap_on_bi_st_ma_re/wall

_street>.

Moffatt, Mike. “What Is the Business Cycle?” About.com. 2008.

The New York Times Company. 16 Nov. 2008.

<http://economics.about.com/cs/studentresources/f/business_

cycle.htm>.

---. “Recession? Depression? What's the Difference?” About.com.

2008. The New York Times Company. 16 Nov. 2008

<http://economics.about.com/cs/businesscycles/a/depressions

_2.htm>.

Public Papers and Addresses of Franklin D. Roosevelt, Volume

Two: The Year of Crisis, 1933. New York: Random House, 1938.

Ramirez, Jessica. “The Difference between a Recession and a

Depression.” Newsweek. 16 Oct. 2008. 16 Nov. 2008

<http://www.newsweek.com/id/164211>.

Weinberg, Ari. “The Great Derivatives Smackdown.” Forbes. 9 May

2003. 13 Nov. 2008

<http://www.forbes.com/2003/05/09/cx_aw_0509derivatives.html

>.

What Is A Subprime Mortgage?” Investopedia: A Forbes Digital

Company.2008. 17 Nov. 2008

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<http://www.investopedia.com/ask/answers/07/subprime-

mortgage.asp>.