Policy Fin Crisis

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Financial Crisis of 2008: Trigger, Events, and Resulting Policies

Lead Up and Trigger of Panic

After a meteoric rise, housing prices in the United States began to recede from

their peak in 2006. There are several factors that led to the housing bubble. An

instrumental component was the implementation of collateralized debt obligations, also

known as CDOs, in the mortgage supply chain. CDOs, in this context, were backed by

the lower and more risky tranches of mortgage-backed securities. These CDOs were then

rated higher than the mortgage-backed securities that they were backed by. This

financial alchemy was justified by the notion that the diversification of mortgages

throughout the country lowered risk. High relative returns and solid ratings sent demand

skyrocketing for CDOs. Incentives aligned with issuing greater volumes of mortgages

rather than focusing on quality. Once mortgages began to default, a vast amount of

positions held by various investors, funds, banks, and companies were adversely affected.

The ensuing aftermath has been coined as the Financial Crisis of 2008.

The months prior to the trigger moment of the financial crisis were an

uncomfortable time period for the markets but foretold little of what was to come. Prior

to the crisis, a few significant events took place. A pivotal moment was when JP Morgan

bought out Bear Sterns, a top-flight investment bank, for $10 a share on March 16, 2008

(Financial Crisis Timeline, 2010). Bear Sterns had revealed an 88%, or a $15 billion,

drop in liquid assets. The Fed had intervened in this particular case to negotiate a buy out

and pledge to fund JP Morgan with up $29 billion in funding for any loss in value of Bear

Sterns assets after the first $1 billion in losses (JP Morgan Announces Amended Merger,

2008). The market was led to believe that any Too Big to Fail, defined as a financial


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institution that is systemically crucial, firm would be rescued the Fed as per the Bear

Stern case (Elliot, 2010). JP Morgans acquisition of Bear Sterns was one of the many

events to occur in the markets during the following months.

On September 15, 2008 Lehman Brothers filed for bankruptcy. This top-flight

investment bank had been experiencing financial troubles for months before. Earnings

reports prior to the bankruptcy stated that Lehman had lost over $2.8 billion in the second

quarter (Financial Crisis Timeline, 2010). The gravity of this bankruptcy was vast and the

implications far reaching. Markets worldwide were sent into a downward spiral after the

bankruptcy. Though it is difficult to isolate and label a particular event for triggering the

financial crisis, there is a considerable amount of backing that the collapse of Lehman

Brothers was the trigger of the financial crisis. A survey conducted by SIFMA yielded

that over 60% of participants believed the bankruptcy of Lehman Brothers to be the most

significant event during the crisis in 2008 (Lehman Brothers Bankruptcy: Lessons

learned from the Survivors, 2009).

Lehman had an extensive global footprint in the credit, derivatives, and equity

markets. A wide host of institutions and people were subject to the fall out as a result.

Over seventy-five separate bankruptcy filings had been filed as a result of Lehmans

insolvency (Lehman Brothers Bankruptcy: Lessons learned from the Survivors, 2009).

The global financial system had been seriously affected by Lehmans collapse and

involvement in the credit and derivatives markets. Prior to Lehmans collapse the

financial markets were still functioning up until the Monday following Lehmans

bankruptcy. On September 15, 2008 markets exploded after news of Lehman going

bankrupt. The Dow Jones Industrial average and Standard and Poor 500 both fell 4.4%


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and 4.7% respectively in one day (Twin, 2008). Under normal circumstances, the bust of

an over-extension of credit results in the retrenchment of credit, defaults on some loans,

the potential failure of some financial firms, and a recession. Outstanding Credit Default

Swaps had put pressure on firms with exposure to Lehmans default risk. Large sums of

capital were required to compensate counter-parties. The pressure and inability to pay off

these debts led to more bankruptcies and created much uncertainty in markets. This

unease amongst investors and firms caused large money runs across the globe.

Institutions that could have survived otherwise were failing because of the lack of credit.

What should have been a boom and bust cycle in the United States turned into a global

financial panic the day of Lehmans bankruptcy.

Main Events of the Crisis

Many events followed the collapse of Lehman Brothers. On the very same day,

the Bank of America acquires Merrill Lynch and AIGs credit is downgraded by the three

major rating agencies. With news of these events, the markets were shrouded in further

uncertainty. Merrill Lynch was another top-flight investment bank. Its sudden acquisition

was ill perceived by the market after the fall of Lehman earlier. Much doubt was cast

upon financial institutions and their sustainability following the housing bubble burst.

The failure and sudden acquisition of two of Wall Streets most prominent banks ravaged

confidence about the future of the financial industry. AIGs credit rating was downgraded

the very same day by all three major rating agencies. The implications of this were that

AIG was required to post billions in collateral to its lenders. AIG had already been

experiencing trouble in raising capital prior to its downgrading. In addition to its existing

lack of capital, AIG was put under tremendous financial pressure once Lehman went


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under due to their CDS exposure to Lehman. AIG, one of the biggest CDS writers, had to

pay back many counter parties for Lehmans default. If AIG were not able to pay its

counterparties, more institutions would go bankrupt.

The RMC money market fund broke the buck following a drop in Lehmans asset

value. RMC had held $785 million debt from Lehman and was forced to write this down

to zero. On September 16, 2008, over $28 billion was pulled form the fund and forced the

net asset value to drop under the sacred $1 mark (Mackenzie and Davies, 2008). Money

markets are assumed to be relatively safe and stable, but RMC breaking the buck

shattered confidence in the money markets. By the next day more funds were coming

under pressure and money markets, a core component of the financial industry, were

freezing up. The effects were evident worldwide because credit flows had practically

frozen. In the following month, stock markets across the globe experienced considerable

drops value with occasional rises. The turbulent market conditions led to government

intervention.

Policy Responses

In the United States, government intervention started before the mania had

erupted. The Fed, FHFA, and Treasury department were given new authority in regards

to the government-sponsored enterprises Fannie Mae and Freddie Mac. Fannie and

Freddie were responsible for buying prime mortgages but then got involved in sub-prime

mortgages. The US government implicitly backed these GSEs. Once the housing bubble

burst, they were unable to execute their task of buying up mortgages effectively. On

September 7, 2008. Fannie and Freddie were placed under conservatorship by the


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government (Financial Crisis Timeline, 2010). This involved a senior preferred stock

purchase from the GSEs. This intervention was conducted with the hopes of stabilizing

the housing market and providing security to Fannie and Freddie debt holders.

On September 16, 2008 the Fed issued a statement that it would loan AIG $85

billion. The US government issued the loan by buying an 80% stake in the company. It

was deemed that AIG was an instrumental player in the financial industry. The Fed went

to the aid of AIG a day after watching Lehman go under because an AIG bankruptcy

would have created systematic problems. According to the heads of a couple bond

investment funds it would have increased borrowing costs and eroded national wealth

(Freed, 2008). Lehman was heavily involved in the CDS market but acted as a broker for

the most part. AIG was one of the biggest writers of CDS. The effects of its bankruptcy

would have spread and caused more bankruptcies and capital concerns for involved

parties. Roughly $307 billion out of $447 billion of AIGs outstanding CDS involved

banks in Europe. A potential bankruptcy could have yielded devastating results for the

European markets (Freed, 2008).

In response to worsening conditions, the Emergency Economic Stabilization Act

was passed into law on October 3, 2008 (Troubled Asset Relief Program, 2008). This law

established the Office of Financial Stability and authorized the Troubled Asset Relief

Program, TARP. This was the first major, non-case by case intervention by the US

government. The purpose of the OFS was to manage and distribute the $700 billion

dollars of funding from TARP. TARP allowed the Treasury department to buy troubled

assets in the form of mortgage backed securities and any other securities the department

deemed necessary for bringing and promoting stability in the markets. On October 14,


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2008 the Treasury announced that it would be shifting emphasis from buying MBS to a

capital purchase program. The Treasury believed that capital injections via warrant and

preferred stock purchases from ailing institutions would be the swiftest mechanism for

stabilizing the financial markets, encouraging interbank lending, and restoring

confidence. Of the funds available, $245 billion have been extended to over 50

institutions across the country (Troubled Asset Relief Program, 2008).

Much debate has ensued following the crisis regarding the regulation of banks.

Critics of the financial system called for stricter regulation and less systematic risk. The

Dodd-Frank Wall Street Regulation Act signed into law on July 21, 2010 is one of the

major responses to the call for greater regulation. It is an expansive law that has created

regulatory bodies to oversee financial institutions. Dodd-Frank has many provisions.

Overall it seeks to protect consumers, ensure stability, increase transparency in the

derivatives market, create tools for handling future crises, and tighten regulation for

financial institutions and rating agencies (The Dodd-Frank Bill: Too Big not to Fail,

2012). Critics of the bill claim it will smother US financial institutions with so much red

tape that the act will do more harm than good. The battle for an efficient balance between

regulation and innovation in the financial industry still ensues.


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Sources

1. Elliott, Douglas. "Financial Reform: Now Its Up to the Regulators." TheBrookings Institution (2010).

2. Freed, Dan. "AIG Bankruptcy Threat Forced Fed's Hand - TheStreet." StockMarket Today - Financial News, Quotes and Analysis - TheStreet.http://www.thestreet.com/story/10437758/1/aig-bankruptcy-threat-forced-feds-hand.html (accessed June 24, 2012).

3. JP Morgan. "JPMorgan Chase and Bear Stearns Announce Amended MergerAgreement and Agreement for JPMorgan Chase to Purchase 39.5% of BearStearns." JP Morgan.www.jpmorgan.com/cm/cs?pagename=JPM_redesign/JPM_Content_C/Generic_Detail_Page_Template&cid=1159339154353&c=JPM_Content_C (accessed June24, 2012).

4. "Lehman Brother's Bankruptcy: Lessons Learned for the Survivors." Address,Informal Client Presentation from PricewaterhouseCooper, London, August 1,

2009.5. Mackenzie, Michael, and Paul Davies. "Money markets fund sector shocked."Capital Markets. www.ft.com/intl/cms/s/0/8bcf03ac-84e1-11dd-b148-0000779fd18c.html#axzz1yk2UnlLR (accessed June 24, 2012).

6. "The Dodd-Frank act: Too big not to fail | The Economist." The Economist -World News, Politics, Economics, Business & Finance.http://www.economist.com/node/21547784 (accessed June 25, 2012).

7. The Economist. "The Dodd-Frank act: Too big not to fail | The Economist."World News, Politics, Economics, Business & Finance.http://www.economist.com/node/21547784 (accessed June 24, 2012).

8. Federal Reserve Bank of St. Louis. "The Financial Crisis Timeline." TheFinancial Crisis Timeline. http://timeline.stlouisfed.org/index.cfm?p=timeline(accessed June 24, 2012).

9. Twin, Alexandra. "CNNMoney.com Market Report - Sep. 15, 2008."CNNMoney.http://money.cnn.com/2008/09/15/markets/markets_newyork2/index.htm(accessed June 24, 2012).

10."TROUBLED ASSET RELIEF PROGRAM." United States GovernmentAccountability Office Report (2008): 1-72.

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