Ten years ago this month – September 2008 – Wall Street took a huge nosedive. Today’s article will provide a summary of what happened in the financial crisis. Next month’s column will focus on how you can prepare for the next financial crisis.
The first clear indication of trouble occurred on March 17, 2008, when investment bank Bear Stearns was purchased in a fire sale by J.P. Morgan. The price was $2 per share, although it was later raised to $10 per share. The Bear Stearns purchase by J.P. Morgan was considered a government bailout because the U.S. government agreed to absorb $29 billion of potential losses (consisting of low-quality mortgage-related assets that Bear Stearns owned) after J.P. Morgan absorbed the first $1 billion of losses. Congress and the American people were not happy that the U.S. government was bailing out a large investment firm that had created its own problems with excessive risk.
Bear Stearns’ stock price was $93 per share in February. How could it plummet so drastically in only one month? To look at the underlying factors, let’s back up several years.
From 1997-2006 housing prices soared by an estimated 85 percent, according to the Case-Shiller index. Many people forgot that real estate is cyclical, and they believed housing prices would continue increasing. During this time, firms such as Countrywide, Washington Mutual, Indy Mac, and many regular banks were breaking rules by writing mortgages later described as low-doc loans, no-doc loans and liar loans. Many mortgage lenders were encouraging people to borrow far more than they could afford. Rather than requiring 20 percent down payments, they were allowing people to buy homes with nothing down. These loans were labeled “subprime” loans because the risk of foreclosure was high.
The investment firms and banks saw an opportunity to make money from all of the new mortgages, and they started bundling the mortgage loans into pools that included subprime loans. These bundles were rated (absurdly) as AA and AAA by major rating agencies, and were sold in the U.S. and abroad as safe, low-risk investments. Fraud and greed were in full swing.
Home prices started to decline in 2006 and did not stop until 2009. According to CoreLogic, housing prices in the U.S. declined an average of 33 percent from 2007 to 2009. When the risk became apparent, the value of subprime mortgages that many investment firms and banks owned declined. By late 2007 regulators recognized that many firms in the financial industry were leveraged 30-to-1 or even 40-to-1. Leverage pertains to debt, and it is not a problem when assets are increasing in value. However, when assets decline in value, it can be disastrous. Economist Alan Blinder, in his book “After the Music Stopped,” states “with 40-to-1 leverage, a mere 2.5 percent decline in the value of your assets wipes out all shareholder value. That’s a pretty risky way to run a business. What were they thinking? Where were the regulators?” The value of the subprime mortgages owned by Bear Stearns plummeted, leading to the purchase by J.P. Morgan.
Although it was not known by most investors, government officials learned that many financial firms owned excessive amounts of low-quality mortgage-related assets, and many were at risk of failure. This became apparent by early September. Fannie Mae and Freddie Mac were nationalized and placed directly under government control on Sept. 7, 2008.
U.S. Treasury Secretary Henry Paulson was intent on not bailing out another firm, and Lehman Brothers was teetering on the brink of failure. Government officials were talking with potential buyers for Lehman Brothers, but when they all backed out, Lehman was forced into bankruptcy on Sept. 15, 2008. On the same day, Merrill Lynch was sold to Bank of America. Merrill’s stock price had declined to $17.05 on Friday, Sept. 12 (from $50 in May 2008 and $90 in January 2007). It was feared that the stock price would drop more on Monday, Sept. 15, so the sale to Bank of America was arranged quickly.
The bad news kept coming. The share price of AIG (a huge insurance company) dropped to $2 per share on Tuesday, Sept. 16. The U.S. government bailed it out with an $85 billion loan, later increased to $182 billion. As part of the deal, the U.S. government owned 79.9 percent of AIG’s stock. During the next few weeks Washington Mutual bank was seized by the U.S. Treasury and sold to J.P. Morgan. Wachovia Bank was purchased by Wells Fargo at a bargain price. On Oct. 3, 2008, Congress agreed to provide Paulson with $700 billion, in a bailout program titled TARP (Troubled Asset Relief Program). It was doled out to firms such as Citigroup, Morgan Stanley, Goldman Sachs, and many banks. Auto firms such as General Motors and Chrysler also received bailouts.
In spite of the implosion on Wall Street, there is some good news. AIG paid back the U.S. in full, and the U.S. government profited from the loan. Only $430 billion of TARP’s $700 billion allowance was dispersed. Most of this was repaid, and the net cost to the U.S. government was estimated to be $32 billion.
The financial crisis was very painful to main street Americans. Many people lost a large part of their savings and investments. It is estimated that the wealth of U.S. households declined $18 trillion. Many Americans lost their homes. Foreclosures tripled between 2006 and 2009.
There was valid criticism that the government bailed out Wall Street, but did not do enough to help people keep their homes. Many people lost their jobs. Unemployment reached 10 percent in October 2009 before it started to decline.
Will there be another financial crisis? Yes, although we do not know when or how severe it will be. Are there safeguards in place to make the next financial crisis less painful? No. Next month’s column will address how you can prepare now for the next financial crisis.