Analyzing the Key Factors Behind the 2008 Market Decline
The fall of 2008 left a lasting scar on the U.S. financial market history, characterized by the subprime mortgage crisis, credit crisis, bank collapses, and government bailouts. This article delves into the critical factors that contributed to the market's decline in the fall of 2008, with a focus on the subprime mortgage market's explosive growth, the role of government-sponsored entities, and the complex financial instruments that played a pivotal role in this historic downturn.
Unprecedented Growth and Consumer Debt
The seeds of the 2008 market decline were sown in the late 1990s when the subprime mortgage market began to experience explosive growth. The Federal National Mortgage Association, or Fannie Mae, embarked on a mission to make homeownership accessible to borrowers with lower credit scores and savings than traditional lenders typically required. While the intention was noble, these subprime borrowers carried higher risk, resulting in unconventional mortgage terms such as higher interest rates and variable payments.
This creative approach aimed to fulfill the American dream of homeownership for all. However, as the subprime market flourished, it raised concerns among some financial experts. Robert R. Prechter Jr., the founder of Elliott Wave International, was a vocal critic of the out-of-control mortgage market, warning that it posed a significant threat to the U.S. economy. As of 2002, Fannie Mae and Freddie Mac had extended over $3 trillion worth of mortgage credit, leading to a precarious situation where confidence was the only thing holding up the market, as Prechter noted.
Adjustable-Rate Mortgages and the Housing Bubble
Among the potentially harmful mortgage types offered to subprime borrowers were the interest-only adjustable-rate mortgage (ARM) and the payment option ARM. These ARMs allowed borrowers to make much lower initial payments than those under fixed-rate mortgages. However, after a few years, typically two or three, these ARMs would reset at higher rates, resulting in fluctuating monthly payments. In the rising housing market of 1999 through 2005, these mortgages seemed risk-free. Borrowers could benefit from rising property values, enabling them to sell their homes for a profit if they couldn't afford the higher payments after the rate reset.
But the danger became evident in the event of a housing market downturn. Many experts warned that these creative mortgage products were a disaster waiting to happen, as falling home prices would leave homeowners in a negative equity situation, making it impossible to sell.
Increased Consumer Debt
Adding to the potential mortgage risk was the rapid growth of total consumer debt, which reached $2 trillion for the first time in 2004. Insatiable investor demand for mortgage-related investments fueled the predatory lending practices leading up to the 2008 crash.
The Rise of Mortgage-Related Investment Products
As housing prices continued to rise, the mortgage-backed securities (MBS) market gained popularity among commercial investors. MBSs pooled mortgages into single securities, allowing investors to benefit from premiums and interest payments made toward the individual mortgages within the pool. The risks associated with these securities became apparent as housing prices began to plummet and homeowners defaulted on their mortgages. Few realized how volatile and complicated this secondary mortgage market had become.
Credit Default Swaps
Another financial instrument that played a significant role in the 2008 market decline was the credit default swap (CDS). Unlike traditional insurance, the CDS market was unregulated, meaning issuers were not required to maintain sufficient reserves to pay out under worst-case scenarios. In 2008, this lack of regulation proved disastrous for American International Group (AIG), a leading financial company that struggled to meet its obligations underwritten in CDS contracts. AIG received a massive $150 billion bailout from the U.S. federal government.
The Markets Begin to Decline
By March 2007, Bear Stearns had failed due to substantial losses linked to the subprime mortgage market, signaling the impending subprime mortgage crisis. As home prices declined, homeowners defaulted on their mortgages, and many found themselves in negative equity situations. The financial markets continued to rise until December 2007 when the U.S. officially entered a recession. The Dow Jones Industrial Average, which had reached its peak in October 2007, began to decline, ultimately falling below 11,000 by early July 2008.
Lehman Brothers Collapses
The collapse of Lehman Brothers on September 15, 2008, marked a turning point in the 2008 financial crisis. It was the largest bankruptcy filing in U.S. history at that time, leading to a substantial drop in the Dow and causing panic in the money market fund industry. Investors' confidence was shaken as the Reserve Primary Fund's share value "broke the buck," and other major financial institutions faced serious challenges.
The Government Starts Bailouts
The government's intervention became crucial in stabilizing the financial markets. On September 18, 2008, talk of a government bailout led to a significant rally in the markets. Treasury Secretary Henry Paulson proposed the Troubled Asset Relief Program (TARP), which aimed to buy up toxic debt and prevent a complete financial meltdown. Simultaneously, the Securities and Exchange Commission (SEC) temporarily banned short-selling of financial stocks to stabilize the markets.
Financial Turmoil Escalates
In the following weeks, the financial turmoil escalated, with the Dow plummeting from its September 19, 2008 intraday high to an intraday low in October. Major events unfolded, such as the conversion of Goldman Sachs and Morgan Stanley to bank holding companies, the seizure of Washington Mutual by the FDIC, and the passage of the Emergency Economic Stabilization Act of 2008. The Dow closed below 10,000 for the first time in years, and President Bush announced an international conference of financial leaders.
The fall of 2008 was a watershed moment in financial history, characterized by the collapse of Lehman Brothers, government bailouts, and unprecedented market volatility. The explosive growth of the subprime mortgage market, coupled with complex financial instruments like mortgage-backed securities and credit default swaps, played a pivotal role in the market's decline. As we look at today's housing market, it is important to note the differences, including homeowners with solid credit, substantial home equity, and locked-in low mortgage rates. However, the lessons from the past serve as a reminder of the importance of vigilance and regulation in the financial industry to prevent similar crises in the future.
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