Components of the 2008 bubble

In 2007, the United States was in a period of economic prosperity. The Internet bubble has become a distant memory. The unemployment rate reached 4.4%, the lowest in ten years, and investor sentiment was high. However, what most investors don’t realize is that their rapidly rising housing prices and soaring stock portfolios are about to hit a wall.

Asset bubbles and financial crises are not new phenomena. Going back to the British rail frenzy of the 1840s, the bubble was a period of excessive prosperity for certain asset classes, and 2008 was no exception.

Just as historians described the Great Depression of 2008 that caused hundreds of thousands of unemployment and the global stock market to evaporate trillions of dollars, it is not just the soaring asset prices and the greed of investors in 2008 that caused the demise of the global economy.

Key points

  • The 2008 financial crisis was caused by several factors such as mismatch of assets and liabilities, excessive leverage, excessive risk, and unreasonable valuation.
  • Due to these problems, some financial institutions have become insolvent, the housing market has collapsed, the stock market has collapsed, and the unemployment rate has soared.
  • In order to prevent a complete economic collapse, central banks around the world have adopted quantitative easing policies: large-scale purchases of national debt and mortgage-backed securities.
  • As a result, interest rates have been suppressed and asset prices have soared, leading to increased inequality.
  • Methods of managing financial crises include providing liquidity to the financial system and building confidence in the security of the banking system.

Factors of economic downturn

In addition to feelings of greed and fear, reviewing historical records shows that there are several factors that contributed to the economic downturn.

1. Mismatch of assets and liabilities

The mismatch of the balance sheet composition of Bear Stearns and Lehman Brothers played an important role in the collapse of these two US investment banks.

With the tightening of credit, banks rely heavily on short-term funds and hold long-term assets based on their funding needs. With the onset of the banking crisis, the liquidity of these long-term assets has become lower and lower, so that when they can no longer be used for financing, the two banks become insolvent.

2. Excessive leverage

As the Great Recession began to unfold, it became clear that investors had high leverage; they had been borrowing large sums of money to invest in assets, essentially increasing their stakes. Although common in financial assets, the collapse of the real estate market is a direct result of leverage.

Homeowners borrowed large sums of money to invest in the booming real estate market, but when the crisis hit and housing prices fell, those who leveraged them became negative tax deductions, and assets could no longer fund debt. This has escalated to the foreclosure of millions of houses, and the housing crisis is proceeding smoothly.

3. Excessive risk

Another component of the 2008 crisis was that financial institutions took excessive risks. As the mortgage crisis unfolded, it became clear that banks purchasing mortgage-backed securities did so on the assumption that they were safe and took very little risk. However, with the widening of credit spreads and the repricing of underlying assets, it is clear that they are by no means risk-free.

4. Valuation

As the post-Internet bubble optimism continues, stock prices are increasingly inconsistent with their valuations. The S&P 500’s price-to-earnings ratio rose above the dot-com bubble high and then soared above 100, which is more than seven times its historical average. As fast as it rises, the transition is equally annoying. In the second half of 2009, the P/E ratio dropped from 123 to 21.

The economic impact of the 2008 bubble

The bursting of the bubble in 2008 was unique. While the unemployment rate is soaring and the stock market crashes, this crisis will be remembered forever because of the unconventional monetary policy of the central bank.

In order to avoid a complete collapse of the banking industry, the Federal Reserve and other global central banks began to purchase US Treasuries and mortgage-backed securities to provide funds for troubled banks. This process is called quantitative easing.

In turn, it suppresses interest rates and encourages borrowing. However, this policy had unintended consequences. First, asset prices have soared; the U.S. stock market has entered a ten-year bull market, and investors have poured into the stock market because of the meager bond returns. As individual holdings of stocks decline, and as record share prices benefit less and less, inequality increases.

In addition, a large amount of capital has flowed into the global economic system, causing global inflation to be lower than the central bank’s target. For the past ten years, the world has been struggling to cope with deflation.

Prevention and mitigation of financial crises

The 2008 bubble was not the first time, and certainly it will not be the last crisis. Crises cannot be prevented or predicted.But as explained in the book Lombard Street (2005) Written by Walter Bagehot, there are some tools to relieve some pain:

  • Provide sufficient liquidity for the financial system: During the 2008 credit crisis, the Federal Reserve and other global central banks lowered interest rates many times to provide the financial system with extraordinary liquidity.
  • Build confidence in the security of the banking system: This prevents consumers from rushing to the bank to withdraw deposits. Confidence can be ensured by providing government guarantees for bank deposits; in the United States, this guarantee comes in the form of an FDIC insurance plan.

Bottom line

As the global economy rebounds from the Great Recession, it is clear that the composition of this crisis is not just a downturn in economic activity and optimism. The lack of supervision by regulatory agencies has led to structural imbalances in banks’ balance sheets. As leverage increases, the risks associated with any adjustments also increase. When this correction comes, these risks become reality.

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