Key Messages
How the Financial Crisis of 2007-2008 Happened and What was Done to Rescue the Economy From Total Collapse
The US government was quick to act when the financial crisis of 2007-2008 threatened to plunge the nation into complete chaos and bankruptcy.
In order to prevent massive amounts of unemployment and abject poverty, they implemented a number of measures to rescue the economy from ruin.
Some of these measures included bailing out key financial institutions, guaranteeing deposits in banks, and providing assistance to citizens directly affected by the crisis.
This assistance came in the form of extended unemployment insurance benefits, increased food stamps, loan modifications, expanded safety net programs and education assistance for children.
These actions were instrumental in saving millions of Americans from unemployment and poverty that could have ensued had the US not acted quickly enough.
The government’s foresight has kept America safe from what would have been one of the darkest periods in modern times.
The Financial Crisis of 2007: Unsustainable Prices in Two Markets
From the year 2000 onwards, incredibly large price bubbles began to form in both the housing and mortgage-bond markets.
In the housing market, prices rose drastically by an average of 85 percent between 1997-2006.
This led more people to invest in houses, believing that they would increase in value year after year.
Understandably this was not a realistic expectation; one Los Angeles survey found many home buyers thought their house value would increase by 22 percent annually!
At the same time, abnormally cut Federal Reserve interest rates had cascaded into the bond market – lowering interest rate for investors who looked for more profitable investments.
Thus causing a price bubble with Mortgage Backed Securities (MBS), or pools of mortgages from which investors can buy from and earn income from interest payments made by homeowners on their mortgages.
These MBSs were highly desirable at a time when the housing market boomed and paid off handsomely due to the risk associated with it.
Poor Regulation Led to the Development of Price Bubbles in the Housing and Bond Markets
The housing and bond market bubbles did not come suddenly.
Rather, they were a result of the poor regulation by banks and the government.
Take the housing bubble for instance: many subprime mortgages were approved for people even when their income levels and credit history should have told lenders to be suspicious.
Banks granted many unreasonable mortgages as long as it served their main goal – to sell lots of mortgages and fuel the booming housing market.
One example is a California couple earning only $27,000 annually being given a mortgage of almost thrice that amount!
It was inevitable that such borrowers wouldn’t be able to keep up with the payment obligations in the long run.
As for the bond market bubble, it was due partly to insufficient understanding of Credit Default Swaps (CDS) – an insurance put on bonds created to protect investors when bonds defaulted.
With an influx of CDS holders, if people began missing payments en masse, then many CDS issuers lacked capacity to pay out as demanded; this is clearly seen in AIG Insurance’s bankruptcy when faced with an overwhelming number of bond defaults.
At its core, it appears that reckless attitude taken both by private bankers and public governing figures brought about these unfortunate events – making poor regulation by both banks and state partially responsible for the housing and bond markets bubbles we saw a few years ago.
The United States Government Had to Rescue the Financial System After the Pied Piper’s Market Bubbles Burst
When the financial bubbles popped in 2007, some of the largest financial institutions around found themselves in or near bankruptcy.
One of the biggest shocks was the downfall of Lehman Brothers, which had been established since the 1850s.
Lehman Brothers had invested too heavily in subprime mortgages, and when those borrowers defaulted on their loans, it was a major blow for them.
The bankruptcy of Lehman Brothers sent shockwaves through Wall Street and caused banks to stop lending to each other out of worry that they would face huge losses.
This put companies like AIG Insurance in an extremely precarious position – if they failed, it would likely plunge the economy into full blown depression.
Thankfully, the Federal Reserve managed to bail AIG out with a $85 billion loan so they could remain solvent and help stabilise the market during such a turbulent period.
Ultimately, it was taxpayers who rescued the financial system and stopped us from sliding into a full blown economic depression after both toxic market bubbles burst.
The US Government’s Troubled Assets Relief Program Averted a Depression and Saved the Economy
In order to prevent the US economy from entering into a depression, the federal government took decisive action by investing in key industries.
The Troubled Assets Relief Program (TARP) was enacted in 2008 to help revitalize the big banks and provide them with capital infusion so that they could remain solvent and pay their creditors.
Not only did TARP allocate nearly $205 billion dollars to 700 different American banks, but it also provided guarantees on financial assets of Citigroup and Bank of America; this reduced fears of these assets failing when the market was weak.
In addition, TARP funds were used to bail out the ailing automotive industry due to rising gas prices, foreign competition and recession that came as a result of the financial crisis.
Thanks to TARP, along with other economic policies, an economic depression was successfully avoided in what is considered by economists one of the greatest investments in US economic history.
ARRA: The Obama Administration’s Attempt to Stimulate Employment Through Fiscal Policy
The US government was determined to stimulate the economy and save jobs, so it took action and enacted the American Reinvestment and Recovery Act (ARRA) in 2009.
This bill was based on John Maynard Keynes’ theories from the twentieth-century, which suggested that increasing government spending or decreasing taxation could help increase demand for goods and services in the economy.
And that’s what the ARRA did – it both decreased taxes and increased spending on things like unemployment benefits, work projects and more, to create new jobs.
It reached its peak during the second quarter of 2009 – $100 billion per quarter- which is estimated to have cost approximately $100,000-$170,000 per job created.
The outcomes of ARRA are still debated by Republicans and Democrats today but it demonstrated the government’s willingness to support private sector businesses in order to bolster the economy.
The Dodd-Frank Act: Understanding the Impact of Reforms on America’s Financial System
In an effort to prevent future disasters in the financial sector, the US government has passed new economic legislation.
This law, known as the Dodd-Frank Act, was signed into law in 2010 and aims to change the way that the financial system is regulated.
The legislation seeks to limit get-rich-quick behavior among leading financial institutions, as well as allowing the government more advanced oversight of potential future economic crises.
It also comes with several other laws designed to protect citizens and their finances, such as preventing taxpayer-funded bailouts for struggling businesses, regulating Wall Street executive compensation so they are not rewarded for taking huge risks, and creating a new agency called The Consumer Financial Protection Bureau.
However, it’s too early to tell how effective this law will be in preventing or alleviating future financial crises.
Implementation has been slow and some changes cannot be rushed since drastic measures could once again lead to panic and confusion.
We may only know how successful this act is when another crisis eventually presents itself.
Financial Institutions Must Regulate Themselves in Order to Purify the Financial System
Stricter government regulation and better banking practices are needed if we want to avoid future financial meltdowns like the one that happened in 2008.
To start, the government needs to regulate the financial sector more closely.
This is something that the Dodd-Frank Act is hoping to achieve, as it seeks to prevent banks from lying about their debts and other irregularities.
At the same time, financial institutions need to take responsibility for regulating themselves by instituting more sensible banking policies.
Many of them chased after unsustainable growth in booming markets without considering whether this was really wise.
This foolishness can be compared to Wile E. Coyote, who continues running even further off a cliff when he should have recognized the danger much sooner!
To prevent another crash like what happened in 2008, financial institutions must take greater care, spotting bubbles earlier on and avoiding actions that could potentially inflate them even further.
Only with stricter government regulation and better banking practices can future financial problems be avoided.
Wrap Up
The final message of the book, After the Music Stopped by Alan Blinder, is that we should be more mindful of taking on large financial commitments such as mortgages and buying bonds.
The author explains that during the early 2000s lots of people were optimistic about the prospects of bonds and houses and rushed to buy them – but ended up losing out when prices suddenly dropped as a result of the financial crisis.
Therefore, it’s important to think long and hard before taking on a mortgage or investing in bonds to make sure you can handle making payments even if prices tank.
That way, you won’t get caught off-guard if something happens with your finances or in the markets.
Ultimately, this book encourages us to not get too carried away with what others say – do your own research and decide what’s best for yourself.
