Panic of 2008 Explained

The 2008 Panic is little understood. We know there was evidence of a sharp downtown. Real estate prices plunged. The stock market collapsed. Investment banking firms on Wall Street failed. Large automobile manufacturers were in peril. Where did the Panic arise? Was there good reason for the financial sector to Panic?

The real Panic occurred in a dimly known and complex, unregulated financial sector, now known as Shadow Banking. Shadow Banking was populated by derivative securities whose value was derived from other sources, much of which was from residential real estate mortgages. 

In fall of 2008 we were informed that the gears of the financial world had locked up. Without immediate intervention a cataclysmic financial event was about to transpire. Absent massive governmental intervention we’d re-live the financial collapse of the Great Depression of the 1930’s. A frenzied colossal demand on the public treasury is made by the Bush administration. Was this just a play to fleece the taxpayers by Wall Street banksters?  

There were many factors contributing to the crisis.  One element was stated governmental policy under the Community Reinvestment Act to increase the number and percentage of citizens, especially minorities, owning a home. A large part of the problem originated when Banks had begun offloading their mortgage loans to Structured Investment Vehicles (SIV). In mid-2007 there were 36 of these non-bank financial institutions, usually situated off shore, totaling $400 billion in assets that gathered large groups of mortgages then spun off derivative securities backed by these mortgages, often subprime mortgages.

The commercial banks (ones that most people maintain their checking and savings accounts) needn’t be so careful about their borrowers, now. Banks would originate mortgages, bundle them then ship them to the SIVs which put them into tranches from prime to sub-prime. They would create residential mortgage backed securities (RBMS). These were acquired by Wall Street investment bankers like Morgan Stanley, Goldman Sachs, Lehman Brothers, Bear Stearns, etc. The last two of these went down in flames in 2008. The other two were secretly supported by the Federal Reserve with unlimited access to the Federal Reserve’s funds in 2009 to keep them afloat; the support amounted to $ trillions in short term borrowings at zero interest.

Housing prices that had seemed set to rise forever surprisingly began to decline. Housing never goes down, right? The first indication for me was the real estate for-sale signs that proudly read, “New Price”. Very interesting to announce a new price; it literally doesn’t tell you much. Is that a lower price or higher price that’s being announced? This forces you to guess that it’s probably a lower price, but makes you wonder why they are being so cute about it. Housing prices went as low as $90, $45 or even $20 thousand (that one was next door) in my community. Who knew? Not many. Maybe the mortgage lenders at the banks originating the lousy sub-prime loans knew, but they didn’t really.* Housing never goes down, right?

Part of the real estate mortgage bubble were teaser loans, no down payment, no principal payments, low interest ARM (adjustable rate mortgage) with balloon payment in 3 years which planned to show equity by the time refinance was due, as house prices continue to rise…oops! Housing prices stopped rising in 2007. People were faced with much higher payments after the initial enticing (ARM) mortgages expired and the need to refinance arrived. They couldn’t even sell the house for the amount of the mortgage, likely to be nearly, if not all of the original amount of the house value, now reduced. How did this torpedo the Wall Street Investment Bankers, the Fanny Mae and Freddie Mac mortgagors, and AIG Insurance?

These investment bankers were the casino gamblers of investment world. In the past Wall Street bankers lived off of fees for underwriting IPO’s (Initial Public [stock] Offerings) or issuance of stock or corporate bonds. They obtained fees for arranging mergers and acquisitions, as well. They did well.

Then the Smartest Guys in the Room (investment bankers) started buying asset backed securities (ABS) and Residential Mortgage Backed Securities (RMBS) using them as collateral and letting large corporate depositors say $500 million to stash money overnight. The RMBS is used as collateral for the party that deposits the cash. The investment bank pays a rate of interest on the cash that is less than the rate earned on ABS. These exchanges are called repos. The investment bank holding the ABS gives the Corporation the ABS as collateral, and the investment bank takes corporate cash, as a deposit. The investment bank makes additional profits when loaning out the cash in short terms loans.

The size of these exchanges is guessed to have been as big as or bigger than the commercial banking sector. In the $ trillions. This was the unregulated Shadow Banking world that the regulators Federal Reserve and FDIC were oblivious to.

All of this business by the investment banks is highly leveraged 20 to 30 times. So the money that’s really backing all this gambling is a fraction of the amount that’s being invested. It’s something like your standard two income family making something like $100k annual income together, deciding to borrow to buy a $3 million dollar home. No danger there? Somebody loses job or gets ill or divorce or any interruption in income will see them losing their house. And so, a hiccup and Wall Street banksters went into the crapper.  

On April 2, 2006, New Century Financial Corporation, a sub-prime mortgage originator files for bankruptcy and becomes a sign things are not all well in the mortgage sector. Many other indications of a downturn in the housing market begin to make themselves known to investors and the market suddenly came to realization that the collateral (these RMBS and ABS) that the Wall Street banksters possess may not be as safe as advertised. By the way, the Federal Reserve Bank wasn’t even looking at the housing market prior to the Panic.

Before the Panic, the investment bank’s collateral, the derivative security, was taken at face value; a $1,000 security would be sufficient collateral for $1,000 in cash. Then as in a run on commercial banks in the past, the investors began to demand more collateral for the same amount of cash deposited. And the crazy part of the panic, the investor began to demand the extra collateral for ALL securities, safe or suspect. Since these securities were so complex, nobody really understood them. Investors began to question them all, even the quality tranches. This is typical of a bank run. All banks suffer the run since the depositor knows nothing of the current financial health of their bank, even a sound one. It’s not just the bank in trouble that faces the panic; they all suffer a run. This is where the financial sector began to freeze up.

Wall Street Banksters were so leveraged they didn’t have the cushion to sustain the shock of a run. Bear Stearns was the first to topple in March 2008. It was bought by Morgan Stanley, which kicked in $1 billion along with a $29 billion loan from the Fed Reserve. Morgan Stanley bought them at $2 a share. Shares had been quoted at $172   January 2007.

What’s more, realizing in part just how risky these derivative securities were, the parties to these transactions thought they covered themselves by purchasing Credit Default Swaps. AIG offered these by the hundreds of $ billions. Investment bankers would find out later just how worthless they were. 

Then this same type of run was made on Lehman Brothers and there was no one to catch it. With their collapse the inter-bank transactions with these repo arrangements froze. That was onset of the Panic. Bush administration and the Federal Reserve were running around like their hair was on fire, not really understanding the cause. But doing everything they could to provide liquidity to the banking system.

The Great Depression in contrast saw the Federal Reserve stand on the sidelines as banks failed by the thousands, a key one was New York Bank of the United States. This saw the collapse of the money supply and financial disaster.

A case where complete collapse was averted was the Panic of 1907, taking place prior to the Federal Reserve Bank being established in 1913. The establishment of the Federal Reserve Bank was setup to prevent these panics. We’ll see shortly how well they performed.

The 1907 Panic saw a sharp downturn in the stock market of nearly 25%, several banks failed and others encountered runs. This is the situation where ALL financial institutions, solvent or no, became suspect and were subject to panicked withdrawals by depositors. Fortunately, the banker J. P. Morgan intervened to summon assistance from other bankers and provide liquidity in the financial system. Something the Federal Reserve failed to provide some 20 years later, whose failure led to the Great Depression. The voting public didn’t want the financial elites like J. P. Morgan bailing out the economy so the Federal Reserve Bank was instituted in 1913. Of course they failed miserably in 1930s to stem systematic bank failure.

The same cooperative assistance between Wall Street bankers could have been contemplated in 2008 but Wall Street knows they have the taxpayers and Federal Reserve to pull their chestnuts out of the fire. The elite 1% are far more clever about pillaging the public treasury than the public. The arcane financial instruments that Wall Street investment bankers had devised backfired on them and the Goldman Sachs bankers within the Presidential administrations knew when their cohorts in Wall Street were in need of relief.

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As stated previously, a significant portion of the 2008 Financial Crisis can be laid on the stated governmental policy by the Community Reinvestment Act to address the lack of minority homeownership. There were presumed racial biases keeping minorities from getting a leg up into owning their own home. The government begins to promote mortgage loans to lower income earners and minorities. Lending standards were degraded. But the commercial banks offload these mortgages to the SIV, as earlier stated. These mortgages are grouped and sold in tranches with assigned risk ratings. The more risky loans with blemishes like recent late pays or low credit ratings or high loan to value ratios or even bankruptcy are placed in the lowest rated tranches.

Part of the financial slump Freddie Mac and Fannie Mae, the giant residential mortage GSOs, that accepted much of this trash, with their tiny to nonexistent capital balances, doomed them to go under. In 2008 they held an estimated $2 trillion sub-prime loans (what a euphemism! Really risky or suspect is more accurate characterization). For example nine years after their massive bailout the 2017 Freddie Mac financial statements showed a negative ($312) million in equity. They were bailed out to the tune of $300 billion, one source reports. It’s certainly not beyond the realm of imagination with their nonexistent capital balances, the US taxpayer will bail them out again sometime in the future.

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The “smartest guys in the room” thought safeguarded themselves from risk by insuring themselves with Credit Default Swaps: Insurance against failure for these risky RMBS and ABS items. Under CEO Martin Sullivan’s guidance AIG (American International Group) issued $ hundreds of billions of these CDS guarantees, never figuring they would have to pay. They were right they didn’t; U.S. tax payers did with $180 billion in bailout money. We’re told they it has been paid back some years later…small consolation.

As an aside to give a picture the size of $180 billion, it’s sufficient to construct a hundred auto plants or skyscrapers. All to the insurance industry. And $300 billion to Fannie Mae and Freddie Mac, who bought $ billions of these sub-prime loans, to the mortgage finance industry. The level of the malfeasance of the finance and investment sectors was astounding!                                                                                                                                                                                                                                            ***

The 2008 panic was accompanied by a great deal of hysteria, especially by the Bush administration, which along with the Federal Reserve was largely clueless themselves. The Bush administration was throwing money around by the hundreds of billions, $700 billion in the TARP (Troubled Asset Relief Program). This was an unfocused program that spread money around to financial institutions including $10 billion each to investment bankers Goldman Sachs and Morgan Stanley. In actuality they found use to expend $431 billion of the appropriated $700.

The Federal Reserve was completely oblivious of the workings of this massive Shadow banking market prior to the 2008 Panic, with its bundled mortgages and corporate paper in SIV’s and repo exchanges. No accurate estimate can be made of the size of this Shadow banking sector was; some estimate it was as large as the known, regulated banking sector itself. For that matter they remained ignorant of the impending collapse in the overinflated housing market.

The Federal Reserve began a nearly decade’s long Zero Interest Policy, by setting its loans at 0.0% in attempts to put liquidity into the banking sector. This included a massive purchase of $ trillions of these suspect RMBS. Even now in 2019 the Fed’s balance sheet is bloated with $3.7 trillion of bonds and RMBS. This was a unheard of policy whose consequences have yet to been determined. So far steady but not spectacular economic growth for past 10 years.

The crux of the Panic was the unexpected decline in the residential real estate mortgage sector; panicky corporate depositors demanded more collateral as question was raised about the safety of the derivative securities like RMBS used for collateral by the Wall Street investment bankers. This is quite similar to a run on a commercial bank and highly leveraged investment bankers couldn’t ante up. The huge Shadow banking sector had frozen up; the fallout from that would be unknown. No one wanted to repeat the Great Depression. The Bush ($700 billion appropriated) and the Obama administrations ($800 billion) spread money about with abandon in hopes the collapse would be stayed.  

The Panic of 2008 differed fundamentally from the Great Depression that originally saw the Crash of the Stock Market in 1929. The Great Depression eventually saw the collapse of the commercial banking system that led to widespread bank failures in the thousands (9,000 approx.). The Federal Reserve, newly established in 1913, making a monumental miscalculation, neglected to stymie the increasing cascade of bank failures. In 2008 the numbers of commercial banks actually failing were few; runs on these commercial banks were nonexistent, as a result of deposit insurance.

*There was an isolated voice in WaMu (largest savings bank at the time), warning of a housing bubble. He was ignored. The company, guilty of purveying suspect residential mortgages, many with little or no documentation, tanked in September 2008, subject to massive runs and  rejection of their mortgages for securitization. But he was only one of the few. Such luminaries as Warren Buffet, Alan Greenspan and Ben Bernanke failed to see the impact of a declining housing market.