The 2008 Financial Crisis
The financial crisis of 2008 was the logical conclusion of free market development of the financial sector–itself the logical result of the incentives of capitalist competition. In that sense, the economic downturn demonstrates the inherent instability of capitalism itself.
The story of the collapse starts and ends in the real estate market. Until a few decades ago, community banks would issue loans to locals. These banks didn’t have a tremendous amount of money to work with, so issuing mortgages was a comparatively big risk for them; they had to make sure their borrowers could afford the loans. But since they were doing business on such a small scale, bankers could develop relationships with their clients in order to make prudent decisions about whom to issue loans to. This worked smoothly enough for several decades.
In the late 1980s, investment bankers got to thinking about this situation. Investors wanted a way to invest in mortgages across the country, so the bankers designed a system whereby they could securitize home mortgages. Banks would buy up many mortgages and pool them together, then sell chunks of the pool to investors. One example of this kind of security is called a Collateralized Debt Obligation (CDO). Ratings agencies–companies that are paid to asses the risk involved with different investments–proclaimed that CDOs were very safe, giving them their highest grade: AAA.
For the first decade or so, the growth of the CDO market was slow. This changed around the turn of the century. Due to government policies, big investors were having a hard time finding profitable places to put their money. It turned out that CDOs offered interest rates up to 3% higher than other similarly graded investments. Money started pouring into the market. In 2004, about $20 billion in new CDOs were issued; three years later this had ballooned to $180 billion.
Banks such as Countrywide Financial Services welcomed this demand for CDOs and changed their business models to accommodate it. Instead of issuing and holding onto mortgages for 15 or 20 years, they started making loans and then selling them almost immediately to Wall Street investors. As demand for CDOs peaked, banks were scrambling to cash in. The demand for investments in mortgages created an incentive for banks to make loans to people who had no hope of ever paying them off.
Soon they ran out of borrowers with good credit. Instead of curtailing their activities, however, banks began issuing “subprime” loans to borrowers who would be less likely to be able to pay them off. Because of the risk, subprime loans imposed much harsher terms on borrowers; even though interest rates usually started low, they often skyrocketed over time. The market for these loans produced a culture of fraud: bankers would convince customers that they could afford loans they could never repay, then help them fraudulently fill out paperwork to get them.
For consumers, this seemed like a dream come true at first. People who had previously had little hope of ever owning a home could suddenly get loans. True, the terms were very bad, but all these new buyers were sending the price of homes through the roof. As long as home prices continued to increase, new home-buyers could purchase homes with subprime loans, then refinance into better loans a few years later when their home values had increased. In short, the entire banking establishment was selling a pyramid scheme.
As banks pooled their subprime loans to sell as CDOs, some Wall Street investors started to look at their investment portfolios. They saw that they owned a lot of these CDOs and that the loans backing them were less and less likely to be repaid. To hedge their positions, they turned to insurance companies, which created policies called Credit Default Swaps (CDSs). These are derivatives based on CDOs that pay the holder if the CDO goes bad. For example, if an investor bought a CDO from a bank, she could also buy a credit default swap from the insurance company covering that CDO; the insurance company would pay her if the bank was unable to pay what it had guaranteed in the CDO.
But, just like a stock option, you didn’t actually have to own a CDO to buy the swap that was based on it–so investors just started trading the CDSs. Pretty soon the size of the CDS market exploded, reaching several hundred times the value of the CDO market–meaning that for every dollar of debt that went unpaid, CDS investors would have to pay out several hundred dollars. The system was incredibly unstable: the market only had to start going downhill a little bit to cause huge effects.
Things started to unravel as early as 2007. More and more struggling homeowners were defaulting on their mortgages; as a result, investors began backing away from CDOs and other mortgage-backed securities. Many investment analysts downgraded their ratings for these products; demand for them soon dried up entirely.
As it became more difficult to sell mortgage-backed securities, banks like Countrywide Financial developed serious problems. These banks depended on re-selling theses securities in order to finance their operations; once the market for CDOs and similar assets dried up, they became insolvent. Many went into bankruptcy or, as in the case of Countrywide, were bought out by larger banks for pennies on the dollar.
Next, a huge Wall Street financial service company called Lehman Brothers was forced into bankruptcy due to its investment in subprime mortgages. The collapse of Lehman Brothers was like a shot heard around the world. Lehman had been a respected pillar of the investment world for over a hundred years; if they could implode, any company could.
Fear spread through Wall Street. Suddenly, anyone with investments in the mortgage market became suspect. AIG, a huge insurance firm, had issued credit default swaps insuring over $440 billion worth of CDOs. Even though AIG had guaranteed that it would pay if these CDOs went bad, the company had never been required to keep enough cash on hand to pay off these obligations. But as the subprime mortgage crises spread, analysts recognized the huge risk in AIG’s policies and lowered the company’s credit rating.
The lower credit rating meant that AIG had to put up a percentage of all the money it had promised through CDS sales. Of course, it had now way to come up with this kind of cash. After Lehman Brothers, the government had decided that allowing these huge companies to go into bankruptcy caused too many problems in the economy, so it stepped in with bailout money. Around this time a number of other institutions such as Fannie Mae, Freddie Mac, Goldman Sachs, and Morgan Stanley all received similar bailouts.
The credit market collapsed. No one knew how much this affected any particular company because the investments were so widespread and complicated. For example, if CitiBank had bought a Credit Default Swap from AIG and then sold one to Merrill Lynch, it might seem that it was not a risk. But if Merrill Lynch came asking for its money and AIG couldn’t pay out, then suddenly CititBank would be responsible for that debt. Faith in the financial market evaporated; almost overnight it became impossible for companies to get loans for practically anything.
This lack of credit quickly trickled down to consumers, sending the real estate market into a nose dive. As credit became less available, demand for houses plummeted and home prices fell through the floor. Suddenly thousands upon thousands of homeowners owed more for their homes than they were worth; this increased defaults. More defaults meant more problems in the financial markets which meant less credit, lower home prices, and more defaults. It was a downward spiral.
The stock market plunged. The value of stocks declined as much as 50%. Combined with the credit crunch, this sent companies into a panic. They began laying off employees by the thousand. Many laid-off employees could no longer afford their mortgages, so they defaulted. This further worsened the financial crisis, which reduced credit availability, which cause more layoffs. Another vicious spiral. At the bottom of the crisis, over 10% of US citizens were out of work–a great deal more if you include those who gave up looking for jobs.
The US government repeatedly attempted to revive the economy, infusing vast sums into the same financial sectors that caused the crash tin the first place. Instead of feeding all this free cash into the US economy, banks and other large corporations hoarded it or put it into overseas investments. So by 2010 corporations were posting huge profits gain; stock market indexes soared, some almost doubling from their lows in 2009. All this while unemployment remained around 10%, much higher in some places, and home prices continued to drop.
The banks who set out to cash in by ripping off home-buyers were simply obeying the imperatives of financial capitalism–those who didn’t were replaced by less scrupulous competitors. The same goes for the home-buyers who took out loans beyond their means and the insurers whose guarantees only made things worse. All of them were acting rationally within the capitalist framework. The problem was that the framework itself is senseless.
In 2008 at the height of the crisis, capitalism was shaken to its foundations. The system had proven that it didn’t work. For the first time in generations, we saw the ones at the top shiver as they realized that the pyramid was a house of cards. One might expect fundamental change in response to such a catastrophe–at the very least, an effort to redistribute wealth similar to the New Deal with which Roosevelt’s government sought to counteract the Great Depression.
Instead we’ve seen the opposite. The capitalists at the top are gambling that they don’t need the US middle class anymore–neither as employees nor as consumers. They had already moved most of their production jobs overseas. Now they’re betting on the emergence of a middle class in China to consume the goods they produce. In the future, if you’re not part of the capitalist class in the US, you’ll serve that class on the cheap, or be out of a job.
The Nazarene Journal
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