The Evolution of the 2008 Financial Crisis

The Marriner S. Eccles Federal Reserve Board Building. Credit: Tim Evanson.

by Fleurat Dedushaj

August 6th, 2015

    In 2008, the United States experienced the worst financial crisis since the Great Depression of the 1930s. The stock market saw huge losses, homes were foreclosed, and banks that were deemed too big to fail, faced insolvency. This was all due in part to years of deregulation, the housing bubble burst, and the repeal of the Glass-Steagall Act. In order to prevent a complete financial meltdown, the Federal Reserve System (the Fed) had to step in.

    The troubles brought upon the United States economy can be traced back to Asia. In 1997, the Thai government was forced to float the bhat, the Thai currency, due to a lack of foreign currency to support its fixed exchange rate. This, along with the vast amount of foreign debt essentially made the country bankrupt. Eventually, this spread to other countries in East Asia as well. In 1998, the Russian government devalued the ruble and defaulted on its debt. These two crises increased the inflow of foreign funds into the U.S., which in turn increased the availability of credit within the states. The increase in credit along with banks’ low lending standards caused an increase in housing sales. The price of homes began to rise, forming a housing bubble. Prices kept rising up until the average home price was $313,600 in 2007. Not surprisingly, the bubble continued to grow until it finally burst and triggered the financial crisis. Once housing prices started falling, banks started to lose money. They had heavily invested in mortgage-backed securities (MBS) and collateralized debt obligations (CDO). These financial assets derive their market value from home prices and mortgage payments. As housing prices declined and mortgage payments fell behind, MBS and CDO prices began to decline as well. Banks were losing so much money that they faced a real possibility of failing. Lehman Brothers, one of the largest investment banks in the world, declared bankruptcy and was liquidated; Bear Stearns and Merrill Lynch were sold for pennies on the dollar. Goldman Sachs, Morgan Stanley, JP Morgan, Citigroup, and Bank of America were able to ride out the storm. However, the economy was spiraling towards a recession and it was up to the Fed’s Federal Open Market Committee (FOMC) to intervene.

    The FOMC oversees the Fed’s open market operations; they influence interest rates through the purchases and sales of treasury securities. Prior to the financial crisis, the Fed held between $700 and $800 billion in treasuries. In November 2008, the Fed began to purchase $600 billion worth of MBS. By June 2010, the Fed held $2.1 trillion in treasuries and MBS. Additionally, they would purchase $30 billion in 2 to 10 year treasuries every month. The reasoning behind the Fed’s purchases, also known as quantitative easing, was to drive down interest rates. In 2008, the FOMC set their target for the Federal Funds Rate (FFR) to be between 0 and .25%. To reach this target, the Fed routinely purchased securities, essentially pumping cash into the economy in order to lower the FFR. Lowering the FFR increases many other things, including the value of stocks. Following the announcement that FOMC would enact quantitative easing, the Dow Jones experienced a 4.2% increase. Most importantly, as quantitative easing relates to the financial crisis, lowering the FFR leads to increased borrowing, which leads to increased consumer spending, business profits, and home sales.

    In essence, quantitative easing fueled increased economic activity. It worked like so: the Fed was purchasing distressed assets in order to provide more capital to banks. At the same time, they were also lowering the cost of credit. Credit enables economic growth as businesses and consumers rely heavily on loans in order to fund their activities, including consumption, day-to-day operations, business expansions, and more. By lowering interest rates, people were more willing to borrow and spend, which helped get the economy back on track. Later in the recession, the Fed announced two more rounds of quantitative easing. QE2 was announced in November 2010, calling for the Fed to purchase $600 billion of treasury securities by the end of the second quarter of 2011. QE3 was announced in September 2013, which called for the Fed to purchase $40 billion of MBS per month. The FOMC also stated that they planned on keeping the FFR near 0% until 2015. It is currently 2015, and the FOMC has announced that an increase in the FFR will likely occur by the end of this year.

    Is the economy ready for higher interest rates? The economy has come a long way since 2007. The unemployment rate, which peaked at 10% in October 2009, is now at 5.3%. Janet Yellen, the chair of the Fed, believes a strong job market combined with low oil prices will cause additional consumer spending. So what is keeping the Fed from raising interest rates? There are some uncertainties. The inflation rate is still below the 2% target set by the Fed. Yellen believes this is explained by the strength of the dollar, which makes imports cheaper for U.S. consumers. Economic troubles abroad are also delaying a rate hike. The Greek debt crisis and the Chinese economy are seen as troubling by the Fed chairwoman. Consequently, we do not know when the Fed will decide to raise interest rates; some say September of this year while others say it will not happen until the end of the year or even until 2016.

References:
Andrews, E. L., & Calmes, J. (2008, December 16). Fed cuts key rate to a record low. Retrieved from http://ezproxy.library.nyu.edu:2646/2008/12/17/business/economy/17fed.html.
Barton, S. W. (2015, July 18). Traders Align With Fed on Inflation as Rate-Hike Bets Intensify. Retrieved from http://www.bloomberg.com/news/articles/2015-07-18/traders-align-with-fed-on-inflation-as-rate-hike-bets-intensify.
Davidson, P. (2015, July 15). Fed’s Yellen reiterates she expects rate hike this year. Retrieved from http://ezproxy.library.nyu.edu:4806/story/money/2015/07/15/yellen-semiannual-report.
Potter, S. (2015, April 15). Money markets and monetary policy normalization. Retrieved from http://www.newyorkfed.org/newsevents/speeches/2015/pot150415.html.
Tucker, M. (2015, June 18). What the Fed needs to consider before a rate hike. Retrieved from http://www.blackrockblog.com/2015/06/18/fed-rate-hike/.