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The Big Claim

            The financial crisis of 2008 was one of the worst financial crisis’s the United States had ever faced. Comparable to the great depression, the consequences of the financial crisis were widespread as it caused millions of homes to be foreclosed on and set record levels of unemployment in the years following. The collapse of financial markets in the United States was caused by the predatory lending practices of loan originators who willfully disregarded risk through lowered lending standards in an effort to yield higher profits.

            The collapse of the housing market in 2008 would have been an avoidable catastrophe if loan originators had not remained willfully ignorant to their fraudulent practices.  The subprime mortgage market began to grow rapidly in the years preceding the crash. Subprime loans are typically packaged and sold off to people with bad credit and reduced payment capacity whom would in turn have a greater risk of defaulting on their loans, so how could such a loan eventually become a multi-trillion dollar market? The answer was simple: foreclosure.

When borrowers were unable to refinance their loans from adjustable to fixed rates they defaulted on their loans. Investment banks and other loan originators would take control of the homes of the borrowers through foreclosure and hope to resell the properties at a profit. This became the goal of the subprime mortgage loan. The subprime mortgage industry did not grow because of demand from the borrower’s side but rather through an increase in supply on the lender’s side. As other financial institutions began to see the potential of such a market they eagerly joined in an effort to reap profit for themselves.

An increase in the number of firms participating in subprime lending creating increased competition within the market. With the increased competition, loan originators needed new ways to sell their subprime loans which lead to a sharp increase in predatory lending practices. Subprime loans were being packaged into loans with “teaser” periods and adjustable rates where borrowers would only pay the interest on the loans for the first two years. After the first two years monthly payments would double or even triple and borrowers would be unable to keep up with payments leading to widespread defaults. With the subprime mortgage market growing rapidly between 2005 and 2007 a ticking time bomb was set in place. Once the teaser periods ended, waves of loan defaults hit the market starting in the third and fourth quarters of 2008 as borrowers failed to make payments on their loans that now had higher interest rates and higher monthly payments leading to the collapse of the housing market.

A detailed diagram listing the causes behind the financial crash of 2008

 The greed of loan originators became its own end. As they sought increased profits through intentionally targeting the uneducated and poorer part of America, they ignored the risks involved in lending and had to pay the consequences. The big plan to profit off the foreclosure of homes in a time when housing prices were at an all-time high backfired. Thousands of small firms filed for bankruptcy across the nation as the shadow banking system they operated on collapsed.

The shadow banking system was where most of the funding for subprime loans came from. Under the shadow banking system these firms did not take direct deposits and were therefore subject to less regulation so larger banking institutions that were subject to greater regulation would fund the shadow banking market in an effort to profit off the subprime mortgage market. Non-bank financial institutions on the shadow banking market, those operating on off-balance sheets to hide their fraudulent practices from regulators, began “repo-runs” on their repurchasing agreements in efforts to regain their short term borrowed collateral. These repo runs became widespread across the shadow banking system, which made up 25-30% of the entire financial system, leading to the failure of many financial institutions. Ultimately the G-20, a group of finance ministers and central bank governors from 20 major economies, summed up the crisis best by stating that “market participants sought higher yields without an adequate appreciation of the risks and failed to execute proper due diligence”. When financial institutions rank profit ahead of risk disaster in eminent.

The "Domino Effect" caused by bankrupting financial institutions.

The collapse of the housing market lead to the creation of a new market. Credit Default Swaps (CDS) because extremely popular in the years just before the financial crash as some speculators caught wind of the inevitable defaulting of subprime mortgage loans and aimed to profit off the default of these loans. When the waves of defaults started rolling in the volume outstanding CDS grew extremely rapidly, growing nearly 100 fold of what it was in early 1999. This created a large betting game played by speculators who tried to figure out which firms were going to be required to pay to cover mortgage defaults. Being lightly regulated, there was no central clearing house (where financial settlements are determined) to honor these CDS in the event that the party to a CDS could not honor their contracts. This lead to widespread CDS losses as large firms such as AIG, Lehman Brothers, and Merrill Lynch were unable to pay the CDS insurance as more of their loans defaulted. Eventually government bailouts were initiated in order to prevent the recession from growing as some of these firms were deemed “too big to fail”.

            The effects of the financial crash and collapse of the housing market were disastrous. According to The Aftermath of the Financial Crises written by Carmen Reinhart and Kenneth Rogoff, the crash not only affected the United States but global markets as well. Between June 2007 and November of 2008 Americans lost nearly a quarter of their net worth. The IMF (International Monetary Fund) estimated that US and European banks lost over 2.5 trillion in toxic loans between 2007 and 2010. Stock market prices fell 57% from their peak in October of 2008.  In every quarter following the 2008 crash hundreds of thousands of jobs were lost and thousands of homes were being foreclosed on. Unemployment levels skyrocketed to over 10% in late 2009 as 8.5 million Americans remained out of work, nearly 6% of the entire workforce. Real GDP growth in the United States was negative starting in the third quarter of 2008 and did not return to growth until the first quarter of 2010.

A diagram listing the effects of the collapse of the housing market.

            With the evidence stacked against them, major corporate leaders such as Howie Hubler were being flamed and held accountable for their roles in the financial crisis. They sought to defend themselves and their actions by claiming that creative destruction was at work. They argued that capitalistic economic development would arise out of the destruction of the previous economic system, one of the key arguments behind the defense of creative destruction. To make such a statement after their own practices lead to the destruction of the previous economic system makes it very difficult to understand their argument of creative destruction, as Robert Skidelsky writes in his NewStatemen article about the role creative destruction played in the crisis of 2008.

New economic growth and development maybe come from the destruction of a previous system but if that previous system was rigged to encourage fraudulent trading only to be intentionally driven into the ground for profit… how can we be so sure that the same will not be repeated in a new system? Sure, there may have been ineffective use of regulatory power by regulators and ineffective crisis management capability by the Federal Reserve when it did not stem the tide of toxic mortgages… but these are the exact changes that can and will be made in the new economic system. There will always been risk involved in trading but if it is acknowledged crisis can be avoided. Altering the system is not as hard as altering the people that run the system. Regulatory legislation can be passed to ensure that all trading done is safe and fair but if the system continues to be manipulated like it had been by the financial institutions then nothing will ultimately change.

As the dust settled in the years following the financial crash of 2008 fingers were being pointed and many questions were being left unanswered. It became clear that the collapse of financial institutions and the housing market was an avoidable catastrophe. The fate of the economic systems in place were unfortunately in the hands of yield seeking Wall Street leaders who willfully disregarded the risks of their actions and chose profit over prosperity.

                           

A video of senator Levin ripping into Goldman Sach's CEO Lloyd Blankfein for his company's practices of selling securities and then buying insurance on those securities knowing that they will fail.