Financial Institutions and Markets Begin to Collapse Summary

  • Last updated on November 11, 2022

Led by a complex web of actions that included a drive to maximize profits and an abandonment of prudence and responsibility, major financial institutions in the United States began to fail. By September, 2008, excessive risk-taking, inadequate cash reserves, excessive debt levels, and the subprime mortgage crisis led to financial collapse. The dire financial condition, coupled with an economic recession in the United States, forced U.S. government interventions that, by November 24, totaled $7.7 trillion in bailouts for these financial institutions.

Summary of Event

On September 7, 2008, the U.S. government took control of the institutions known as Fannie Mae Fannie Mae (Federal National Mortgage Association) and Freddie Mac Freddie Mac (Federal Home Loan Mortgage Corporation). These government sponsored entities, whose purpose was to guarantee and purchase mortgages for low- and moderate-income applicants for home loans, had funded nearly two-thirds of all mortgages sold in the United States. [kw]Financial Institutions and Markets Begin to Collapse (Sept. 7, 2008) Financial industry, collapse of Bernanke, Ben Paulson, Henry Mortgage industry Economic bailouts Bailouts Recession, U.S. Financial industry, collapse of Bernanke, Ben Paulson, Henry Mortgage industry Economic bailouts Bailouts Recession, U.S. [g]United States;Sept. 7, 2008: Financial Institutions and Markets Begin to Collapse[03880] [c]Banking and finance;Sept. 7, 2008: Financial Institutions and Markets Begin to Collapse[03880] [c]Economics;Sept. 7, 2008: Financial Institutions and Markets Begin to Collapse[03880] [c]Government Sept. 7, 2008: Financial Institutions and Markets Begin to Collapse[03880]

Following the takeover of Fannie Mae and Freddie Mac was the collapse of the investment bank Lehman Brothers Lehman Brothers on September 15, amounting to the largest bankruptcy filing in U.S. history. The following day, the U.S. Federal Reserve, Federal Reserve, U.S. led by Ben Bernanke, loaned AIG AIG (American International Group) (American International Group), one of the world’s largest insurance companies, $85 billion in exchange for nearly 80 percent of its stock. By September 22, all five Wall Street investment banks Wall Street investment banks (including Lehman Brothers, Merrill Lynch, Merrill Lynch Morgan Stanley, Morgan Stanley and Goldman Sachs Goldman Sachs ) had either gone bankrupt, been sold, or been restructured.

A protestor holds up a sign behind Treasury secretary Henry Paulson, left, and Federal Reserve chair Ben Bernanke at a hearing of the Senate Housing and Urban Affairs Committee on September 23, 2008, in Washington, D.C. The committee began hearing arguments from federal officials for a $700 billion government bailout of American financial markets.

(Hulton Archive/Getty Images)

On October 3, a $700 billion government rescue plan was signed into law. On October 14, the Treasury Department, U.S. U.S. Treasury Department, led by Henry Paulson, said it would spend $250 billion to purchase stock in banks, hoping to unfreeze credit markets. The first $125 billion would be spent on forced purchases in the nine largest depository banks, a move that amounted to partial nationalization. By October 27, fifteen smaller banks had taken funding from this federal allocation. On November 23, the U.S. government agreed to guarantee $306 billion in troubled assets held by Citigroup, Citigroup one of the world’s largest financial services firms.

All financial systems have a measure of risk built into them, but in healthy economies these risks are balanced by the prudent management of assets in the private sector and an effective set of public sector (governmental) regulatory practices that control risk while encouraging innovation. However, between 2000 and 2008, this ideal of balance disappeared as regulators lost power and financial managers found themselves with new freedoms to design and market risky new financial instruments.

Between 2001 and 2007, securitization (the process of pooling debt—such as mortgages—then packaging it and selling it to investors) produced sales for U.S. financial firms of $27 trillion, almost twice the 2007 U.S. gross domestic product. Part of this process of securitization was the use of so-called structured finance to create complex investments. However, there were dangers inherent in these investments. On October 21, 2008, Joseph E. Stiglitz, Stiglitz, Joseph E. who had been awarded the 2001 Nobel Prize in Economics, told a congressional hearing on financial services regulation that

Securitization was based on the premise that a “fool was born every minute.” Globalization meant that there was a global landscape on which they could search for those fools—and they found them everywhere. Mortgage originators didn’t have to ask, Is this a good loan? but only, Is this a mortgage I can somehow pass on to others?

These structured finance products would not have been sold in such vast quantities had they not been portrayed as safe and high quality. The financial firms that put together these products also ensured buyers that the products were triple-A rated and insured. Unfortunately, both of these protections proved to be flawed.

The excesses and failures of the credit rating companies (Moody’s Moody’s[Moodys] ; Standard and Poor’s Standard and Poor’s , or S&P; and Fitch Fitch ) played a crucial role in the financial crisis. Both Moody’s and S&P testified before the U.S. Congress that they accepted raw data on the securitized mortgages underlying these products without checking that data. The two companies testified that they had revised their ratings models in 2004 in ways that eased the rigor of the ratings and kept the companies competitive in giving top ratings. Perhaps the most troubling issue, however, was that the credit rating companies were paid by the financial firms whose products they were rating. Moody’s analysts admitted that on several occasions they raised their ratings on pools of mortgage-backed securities issued by Countrywide Financial Corporation Countrywide Financial Corporation after Countrywide complained about initial ratings.

Investor protection, through insurance, also was flawed. Structured finance products are insured by what are called credit default swaps (CDS). CDS are private contracts protecting parties, usually banks, against defaults on debts, and they have a global reach. The financial products unit of insurance giant AIG began in 1998 to sell CDS that were tied to mortgage-backed structured finance products put together by Citigroup, Merrill Lynch, and others. The deals earned AIG around $750,000 each. Over time, more and more of these products contained subprime mortgages. The Commodity Futures Modernization Act of 2000, Commodity Futures Modernization Act of 2000 sponsored by U.S. senator Phil Gramm, had ensured that CDS would remain unregulated. As a result, the CDS market grew from over $100 billion in 2000 to $62 trillion at the end of 2007. The sheer size of this global market led to concerns that financial firms issuing a large volume of CDS might set off a chain reaction if they failed. These concerns, however, went unheeded, and the financial system began to collapse.

By the time AIG stopped all of its CDS and subprime mortgage-related business in the summer of 2005, it had insured 420 structured finance deals, making $315 to $400 million but assuming a debt of $63 billion. The U.S. government bailout of AIG provided $85 billion to the failing company on September 16, 2008, but later increased the amount to $123 billion.

Another critical U.S. regulatory change in the early 2000’s had allowed banks to keep mortgage-related structured finance products off their balance sheets (that is, they were not required to include them in their financial report that summarizes their total assets, liabilities, and shareholders’ ownership stakes). Investors were thus left uninformed about the nature and amount of risk that banks held. Also, the U.S. Office of Thrift Supervision, Office of Thrift Supervision, U.S. which regulates thrifts (also called savings and loans), including Countrywide, IndyMac, IndyMac Washington Mutual, Washington Mutual and Downey Downey Savings and Loan —all heavily involved in mortgage lending—permitted these institutions to take excessive risks. These risks included allowing the companies’ reserves to decline to the lowest level in two decades. The thrifts also were allowed to expand risky forms of loans, such as option adjustable-rate mortgages. By 2008, several of these companies had been seized by regulators or forced to sell themselves to avoid failure.

Excesses and risk also were at the root of Fannie Mae’s and Freddie Mac’s failure. During the subprime mortgage boom, mortgage lenders, including Countrywide, threatened to sell directly to Wall Street firms (including Goldman Sachs, Lehman Brothers, and Bear Stearns Bear Stearns ) unless Fannie Mae would buy some of its riskier loans. Thus, between 2005 and 2007, Fannie Mae took on more and more subprime and Alt-A loans (those for which applicants did not have conventional documentation of their income or assets). Risk officers and other officials warned of the dangers involved in these practices, but by December, 2008, the two owned or guaranteed one in three subprime mortgages and almost one in two Alt-A loans, comprising 34 percent of their single-family mortgage holdings.

Impact

Criminal investigations began quickly, and by late September, 2008, the Federal Bureau of Investigation Federal Bureau of Investigation;and financial markets collapse of 2008[financial markets collapse] had opened twenty-six preliminary fraud investigations, including investigations of Fannie Mae, Freddie Mac, Lehman Brothers, and AIG. The U.S. Securities and Exchange Commission Securities and Exchange Commission, U.S.;and financial markets collapse of 2008[financial markets collapse] (SEC) opened more than fifty investigations of insurers, banks, and credit rating firms. The SEC charged Fannie Mae and Freddie Mac with having committed accounting fraud in 2006 and 2007, and the two paid $450 million in penalties. On December 11, 2008, the trustee in charge of the liquidation of Lehman Brothers (already the subject of other investigations) asked the bankruptcy court for subpoena power to investigate the collapse of Lehman Brothers.

Several class action lawsuits were filed against the financial firms for violations of securities law. Securities are financial instruments that may be publicly traded, such as stocks, bonds, and mutual funds. On December 4, 2008, a class action lawsuit was filed against Citigroup on behalf of investors who had purchased Citigroup stock between January, 2004, and November 21, 2007. One successful lawsuit was filed on the principle of breach of fiduciary duty, which is a legal duty of care and good faith to act only in the interests of the beneficiary (for example, a company’s shareholders). The Teachers’ Retirement System of Louisiana sued four former executives of AIG for breach of fiduciary duty. On September 30, 2008, parties to the suit announced a settlement of $115 million.

By the end of September, government leaders from around the world were openly blaming the United States, particularly the federal government, for allowing the crisis to fester and thus threaten markets and economies worldwide. World leaders denounced everyone from financial speculators to managers of global financial firms who took huge risks out of greed.

The financial crisis, combined with the global recession, had a startling impact on not only the U.S. financial markets and economy but also the world economy. By late October, overall U.S. stock market losses amounted to $8 trillion for the preceding fifteen months, affecting savings and retirement accounts as well as endowments, pension funds, and international investments. By November 21, the S&P 500 stock index was down 46 percent from its peak.

On November 15, leaders of the Group of 20 (the largest developed and emerging-market world economies), which had been meeting in Washington, D.C., issued a lengthy, detailed statement on what they believed caused the financial collapse. The statement included many suggestions for reform (both immediate and medium-term) to prevent another collapse. The size of the U.S. government’s intervention showed that these reforms were clearly needed. By November 24, the day after the U.S. government guarantee of Citigroup’s debt, the combined amount of government funding pledged in the various parts of the financial bailout was $7.7 trillion. This equaled $24,000 for each person in the United States. Financial industry, collapse of Bernanke, Ben Paulson, Henry Mortgage industry Economic bailouts Bailouts Recession, U.S.

Further Reading
  • citation-type="booksimple"

    xlink:type="simple">Mizen, Paul. “The Credit Crunch of 2007-2008: A Discussion of the Background, Market Reactions, and Policy Responses.” Review (Federal Reserve Bank of St. Louis), September/October, 2008. A detailed, scholarly examination of the financial crisis, with special attention to its global dimensions.
  • citation-type="booksimple"

    xlink:type="simple">Roubini, Nouriel. “The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster.” RGEmonitor, February 5, 2008. Predicts several of the events of the financial crisis. Explains in detail the conditions that contribute to each step in such a crisis.
  • citation-type="booksimple"

    xlink:type="simple">Roush, Chris. “Unheeded Warnings.” American Journalism Review 30, no. 6 (December/January, 2009). Documents extensive coverage, beginning in 2000, of the conditions that led to the financial crisis. Includes discussion of coverage by The New York Times, The Wall Street Journal, the Washington Post, Fortune, and Business Week.
  • citation-type="booksimple"

    xlink:type="simple">United States Congress. House of Representatives. Committee on Financial Services. The Future of Financial Services Regulation. Washington, D.C.: Government Printing Office, October 21, 2008. Offers clear and wide-ranging testimony by Joseph E. Stiglitz on the regulatory causes of the financial crisis. Stiglitz discusses topics such as transparency, securitization of mortgages, excessive corporate risk-taking, executive compensation, off-balance-sheet accounting, exploitive lending practices, and credit rating agencies.
  • citation-type="booksimple"

    xlink:type="simple">Zandi, Mark. Financial Shock: A Three-Hundred-Sixty Degree Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis. Upper Saddle River, N.J.: Financial Times Press, 2008. Readable, thoroughly documented, comprehensive examination of the roots of the financial crisis. Discusses the Federal Reserve’s policy of extremely low lending rates, the roles of various types of mortgage buyers (first-time, trade-up, investors, and flippers), overseas investors, mortgage bankers and brokers, structured finance, the credit crunch, and more.

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