The Consequences of the Financial Crisis of 2008 for the US Economy

By the definition given at Investopedia social web site a financial crisis is A situation in
which the value of financial institutions or assets drops rapidly. A financial crisis is often
associated with a panic or a run on the banks, in which investors sell off assets or withdraw
money from savings accounts with the expectation that the value of those assets will drop if they
remain at a financial institution. The definition precisely illustrates what happened literally few
years ago. The 2008 financial crisis is a cause of change in many peoples lives because millions
lost their savings, jobs, property and probably a better future.
The roots of the financial crisis of 2008 took place in early 1980s when the Investment
Bank went public. At that time the CEO of Merrill Lynch bank, Donald Regan, was chosen to be
treasury secretary. With his help in 1982 the process of deregulation of the economy was started.
As the rusult, some bank regulations were reduced allowing banks make risky investments with
depositors savings. Since that time banks were engaging in operations that would promise
bigger earnings but might cause severe consequences.
In early 2000s the United States came across high inflation problem and tried to cope
with it. Trying to tame the inflation and stimulate the economy growth the central bank managed
to lower the interest rate what created good conditions for borrowing and technically speaking
gave banks an opportunity to use leverage to earn even more money. Because, the situation was
accompanied with an astonishing building boom across the United States and mortgage
borrowing was becoming more and more popular, financial intermediaries borrowed from the
Fed to buy out more mortgage securities from lenders. Investment banks combined those
securities and transformed them into CDO (Collateralized Debt Obligation). Those CDOs were
exposed to evaluation and rated by rating agencies such as AIG and then sold to investors who
would get more attractive payments from home buyers on their investments in compare to 1%

that the central bank would pay. Initially, mortgage payments came directly to lenders, but now
lenders serve just as intermediary between investors and home buyers.
With time, the mortgage market ran out of reliable home buyers who could really cover
their loan and pay the interest. Since the time the mortgage loan system switched from borrower
lender relationship to one where lenders did not care much about financial soundness of their
debtors, lenders continued giving out risky mortgages, subprime mortgages. The brokers offered
the loan literally to anyone in order to get as much commissions as possible and had no problems
if a borrower was not able to pay out the loan because they resell the mortgages to investment
banks. No one in the market really cared if borrowers could pay out loans, and everybody was
sure that if something goes wrong, someone else is going to incur losses.

The graph illustrates the situation that occurred at the mortgage market. We can see on
that the amount of mortgage borrowings was increasing tremendously since the very end of
1990s right to 2008. A big share of all mortgages given out during the period may be attributed
to subprime loans. The investment banks preferred subprime loans because first, they carried
higher interest rates and thus were more demanded by investors, and second, the also had AAA
quality because banks paid rating agencies to have a good rate.

Trying to earn profit on leverage they borrowed more funds from the Fed and the Fed did
not do anything to limit those amounts. Thus, many banks increased their assets tremendously
comparing to the worth of their equity. For example, Goldman Sachs used its $40 billion of
equity as the foundation for creation $1.1 trillion of assets.
To prevent losses that might occur in case the CDOs default in early 1990s some
insurance companies, such as AIG, created a new type of security, Credit Default Swap. The
usage of it increased after 2003 when investors started to predict future failure of CDOs. For
investors and banks CDS was like insurance. They paid premiums to insurance companies and
those companies took responsibilities to cover all the losses if CDOs went bad. In particular,
AIG, the largest insurance company in the world, made big profits on insuring investors CDOs.
It also increased profits due to premiums it received from speculators predicting soon CDOs
default. For example, anybody could buy CDS from AIG to insure CDOs even not having it.
Thus, if something went bad on real estate market AIG was supposed to cover expenses that
were much bigger than profits it made. Intermediaries were taking risks to gain profits in the
short term, but those risks might destroy them in long run.
Because anyone could buy a house, its price skyrocketed creating a large financial
bubble ever. Many banks gave out huge loans. Eventually, in June 2006 the price of homes
reached its peak causing the values of all securities tied to US real estate to go down. Many
people understood that real estate was overestimated and did not want to pay that much. Another
reason was that borrowers started having problems with foreclosures and were not able to pay
out debts and banks took those houses away and sold them. The number of such houses was
increasing and some people did not want to borrow more because prices went down, so they did
not want to pay more when there were cheaper homes for sale. The graph below demonstrates
what was happening at that time. We can see that when people began unwilling to pay extra
costs for property that does not worth it and when there lots of houses on the market appeared for
sale because borrowers could not manage loan payments that created problems to anyone who

possessed CDOs. Less people trust in CDOs stability and that caused the recession started in
2007.

The sutuation on the market made an impact on Goldman Sachs investment bank. It
expected CDOs to default in the nearest future and started to get rig of it telling people that those
securities are high quality. It also purchased CDSwaps from AIG so to have payments on CDOs
if it would go bad. The tatoal worth of purchase was $22 billions. Obviously Goldman Sachs was
not the only investment bank that insured CDOs. Consequently, the amount insured by AIG was
so high that Goldman Sachs was afraid it could go bankrupt and spent $150 millions more to
insure itself aganst AIG potential collapse. In a word, Goldman Sachs would benefit in either
way if CDOs dafaulted or stayd sustainable.
In 2008 the markedt for CDOs failed. Lenders could no longer sale their loans to
investment banks and when loans went bad they failed. At the same time, investment banks held
billions of debts and houses they were not able to sell.
In march 2008 almost all depositors lined up in front of banks to withdraw their money.
Most of the banks invested too much to subprime mortgages and people did not want to pay for

banks default. In March 2008 Bear Stearns was ran out of cash and almost went bunkrupt. Its
shares fell down in price incredibly from $170 to $2 per share and wasd bought out by JP
Morgan. In september another couple of two big mortgage lenders was taken over by the Fed. In
Saptember, Lehman Brothers and banking industry was falling down. The graph below
represents the amount of the loans taken by the banking system of the United States from the
Fed.

As we can see, when the recession started in 2007 banks began borrowing from the Fed,
so to increase their reserves and give out cash to people withdrawing their deposits. Because
public took money out of the banks, the money supply in the economy was reduced. The amount
of currency on hand increased but because the amount of deposit decreased, the deposit
multiplier decreased too that lead to total decrease in money supply. That means the economy
gets into even a bigger trouble. Because consumers cut back on spending during the recession
they do not spend as much money and, consequently, buy less. It affects not only the US
economy, but also the whole world. For example, there are many products produced in China
and sold in the US. Since Americans do not spend as much and do not buy those products, the
manufacturers in China cut the labor and many people there worse off.

The financial crisis of 2008 made a huge impact on the US economy as a whole where we
can see both; changes in household life and the monetary policy. Federal Reserve estimated that
during the recession from 2007 to 2009 the country lost about $14 trillion which equals to almost
an entire year's worth of economic activity. The crisis brought many people to joblessness and
homelessness. The economic dominance had declined because the leading industries of the US
such as US steel and Chrysler are not the leaders on the worlds market anymore. More and more
business moves to China, where labor is cheaper, but people in the US cannot find proper job.
Today, manufacturing sphere declined, but informational technology rose. The country is a
leading IT industry in the world and it is not very hard to find a job with high salary in IT
company. But the problem is that to get that job people need education financing of what has
been considerably reduced and the majority of people cant simply afford it. That also means that
the financial crisis has brought not only poverty and losses to the country, it also made a gap
between rich and poor people broader which eventually may bring the US to the lower level in
the worlds market.

The Federal Reserve was not founded to bail out Bear Stearns or a few hedge funds. It was
founded to keep a stable currency and maintain its value. - Jim Rogers, Rogers Commodity Fund

http://www.investopedia.com/terms/f/financial-crisis.asp Financial crisis definition

http://research.stlouisfed.org/fred2/series/MLBSNNCB

Nonfinancial Corporate Business;

Total Mortgages; Liability (MLBSNNCB)

http://research.stlouisfed.org/fred2/series/HPIPONM226S?rid=171 Purchase Only House

Price Index for the United States (HPIPONM226S)