Causes of the Crisis
In 2006, real estate prices began to decline for the first time in decades. Initially, real estate agencies welcomed this development. They believed that the overly heated real estate market would return to a more sustainable level. They did not take into account a number of factors, such as the presence of many homeowners with questionable credit who were approved for mortgage loans, some even for more than 100% of the home’s value.
Some blamed the Community Reinvestment Act, which pressured banks to invest in poor areas. Several studies conducted by the Federal Reserve found that it did not increase risky lending.
Others blamed Fannie Mae and Freddie Mac entirely for the crisis. For them, the solution was to close or privatize the two agencies. If they were shut down, the real estate market would collapse because they guaranteed the majority of mortgage loans.
Financial derivatives were licensed without regulatory oversight. Any state legislation was also bypassed. Large banks had the resources to manage these complex financial instruments.
Among these products, mortgage-backed securities had the most significant impact on the real estate market. The profitability of mortgage-backed securities led to increased demand for the loans underlying them.
Investment funds and other financial institutions around the world held mortgage-backed securities, but they were also in mutual funds, corporate assets, and pension funds.
Pension funds purchased these risky assets because they believed a type of insurance product called credit default swaps protected them. American International Group (AIG) provided these swaps, and when the derivative instruments lost value, they did not have enough cash flow to honor all of the swaps.
In 2007, banks began to panic as soon as they realized they would have to absorb the losses, and they stopped lending to each other. They did not want other banks to provide them with worthless mortgages as collateral, and as a result, borrowing costs among interbank lending, known as LIBOR, rose. The Federal Reserve began injecting liquidity into the banking system through a term auction facility, but this was not enough.
Cost of the Crisis
The chart below details the cost of the 2008 crisis.
The financial crisis of 2008 began in March 2008 when investors sold shares of investment bank Bear Stearns because it had too many toxic assets. Bear approached JPMorgan Chase for a bailout, but the Federal Reserve had to sweeten the deal with a $30 billion guarantee. The situation on Wall Street deteriorated throughout the summer of 2008.
Congress authorized the Secretary of the Treasury to take over the mortgage companies Fannie Mae and Freddie Mac – costing him $187 billion at that time. On September 16, 2008, the Federal Reserve loaned $85 billion to AIG as a bailout. In October and November, the Federal Reserve and the Treasury Department restructured the bailout, raising the total amount to $182 billion. By 2012, the government turned a profit of $22.7 billion when the Treasury sold its final shares in AIG.
On September 17, 2008, the crisis led to a flight of money from money market funds where excess corporate cash was placed to earn interest overnight, and banks then used this cash to make short-term loans. During this period, corporations moved $172 billion from their accounts in the money market to bond securities.
Source: https://www.thebalancemoney.com/2008-financial-crisis-3305679
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