The fall of the market in the fall of 2008

The mortgage crisis. credit crisis. The bank went bankrupt. Government bailout. Throughout the fall of 2008, such phrases frequently appeared in headlines. This period is also one of the most terrifying periods in the history of American financial markets. Those who have experienced these events may never forget this turmoil.

So what happened and why? Read on to learn how the explosive growth of the subprime mortgage market that began in 1999 played an important role in laying the foundation for the turmoil of the stock and real estate market crash in 2008, just nine years later.

Key points

  • The stock market and real estate crash in 2008 stemmed from the unprecedented growth of the subprime mortgage market that began in 1999.
  • The US government-sponsored mortgage lenders Fannie Mae and Freddie Mac provide home loans to borrowers with low credit scores and a higher risk of loan default.
  • These borrowers are called “subprime borrowers” and are allowed to apply for adjustable-rate mortgages. This type of mortgage starts with a low monthly payment and will grow larger in a few years.
  • Financial companies sell these subprime loans to large commercial investors in the form of a pool of mortgage loans, called mortgage-backed securities (MBS).
  • By the fall of 2008, borrowers defaulted heavily on subprime mortgages, leading to financial market turmoil, stock market crashes, and the subsequent global recession.

Unprecedented growth and consumer debt

Subprime mortgages are mortgage loans for borrowers with poor credit and insufficient savings. The increase in subprime loans began in 1999, when the Federal National Mortgage Association (commonly known as Fannie Mae) began to work together to make it easier for people whose credit and savings are lower than the lender’s usual requirements to obtain home loans.

The idea is to help everyone realize the American dream of owning a house. Because these borrowers are considered high-risk, their mortgages have unconventional terms that reflect this risk, such as higher interest rates and variable payments. As the subprime mortgage market began to explode, many people saw a huge boom, while others began to see red flags and potential economic dangers.

Robert R. Prechter Jr., founder of Elliott Wave International, has always believed that the out-of-control mortgage market poses a threat to the U.S. economy because the entire industry depends on rising real estate values. As of 2002, government-sponsored mortgage lenders Fannie Mae and Freddie Mac had provided mortgage loans worth more than US$3 trillion.In his 2002 book Conquer the collapse, Prechter said, “Confidence is the only factor that supports this huge house of cards.”

The role of Fannie Mae and Freddie Mac is to repurchase mortgage loans from the lender who initiated the mortgage loan and make money when the mortgage bill is paid. As a result, rising mortgage default rates have led to a sharp decline in the revenue of these two companies.

Adjustable rate mortgage

Among the mortgages provided to sub-prime borrowers, the most fatal ones are the interest-only ARM and the payment option ARM, both of which are adjustable rate mortgages (ARMs). Compared with fixed-rate mortgages, the down payment of the borrower for these two types of mortgages is much lower. After a period of time, usually only two to three years, these ARMs will be reset. The payment then fluctuates as frequently as every month, usually becoming much larger than the initial payment.

In the upward trending market that existed from 1999 to 2005, these mortgages were virtually risk-free. Although mortgage payments are low, borrowers may eventually get positive assets because their homes have appreciated in value since the date of purchase. If they cannot afford a higher payment after the mortgage interest rate is reset, they can sell the house to make a profit. However, many people believe that these creative mortgages are a disaster waiting to happen in the downturn of the real estate market, which will leave the owners in a negative equity situation and cannot sell them.

Increased consumer debt

In order to exacerbate the potential mortgage risk, overall, the total amount of consumer debt continues to grow at an alarming rate. In 2004, consumer debt reached US$2 trillion for the first time.

The rise of mortgage-related investment products

During the period of rising house prices, the mortgage-backed securities (MBS) market was welcomed by commercial investors. MBS is a pool of mortgage loans combined into a single security. Investors benefit from the premium and interest payments on personal mortgages included in the securities.

As long as housing prices continue to rise and homeowners continue to pay for mortgages, this market can be highly profitable. However, as housing prices began to plummet and homeowners began to default on mortgages in droves, the risk became very real. At the time, few people realized how turbulent and complicated this secondary mortgage market has become.

During this period, another popular investment tool was credit derivatives, called credit default swaps (CDS). CDS is intended as a way to hedge the reputation of a company, similar to insurance. But unlike the insurance market, the CDS market is not regulated, which means that the issuer of the CDS contract is not required to keep sufficient funds in its reserves to pay in the worst case (such as a recession). This is exactly what happened to American International Group (AIG) in early 2008, when it announced that its underwriting CDS contract portfolio had a huge loss that could not be paid.

150 billion U.S. dollars

The amount of aid funds received by AIG from the U.S. Federal Government in 2008, The company repaid with interest in 2013.

The market starts to fall

By March 2007, Bear Stearns went bankrupt due to huge losses caused by underwriting many investment instruments related to the subprime mortgage market, and the entire subprime mortgage market was clearly in trouble. The homeowner’s default rate is high, because all the creative variants of subprime mortgages are resetting to higher repayments as house prices fall.

Homeowners are upside down—they owe more mortgages than the value of their house—if they can’t make a new, higher payment, they can’t move out of the house. Instead, they lost their homes due to foreclosure and often filed for bankruptcy in the process. The subprime mortgage crisis began to affect homeowners and the real estate market.

Despite this apparent chaos, financial markets continued to rise in October 2007, and the Dow Jones Industrial Average (DJIA) reached a closing high of 14,164 on October 9, 2007. The turmoil finally caught up, and by December 2007, the United States had fallen into recession. By early July 2008, the Dow Jones Industrial Average will drop below 11,000 for the first time in more than two years. That will not be the end of the recession.

Lehman Brothers collapses

On September 6, 2008, the financial market fell by nearly 20% from its peak in October 2007. The government announced the acquisition of Fannie Mae and Freddie Mac. This was due to the massive losses caused by the collapse of the subprime mortgage market. A week later, on September 14, the large investment company Lehman Brothers succumbed to its excessive investment in the subprime mortgage market and announced the largest bankruptcy application in the history of the United States at that time. The next day, the market fell sharply and the Dow closed 499 points lower at 10,917.

The collapse of Lehman Brothers caused the net asset value of the Reserve Junior Fund to fall below $1 per share on September 16, 2008. Investors were subsequently told that for every dollar invested, they would only get 97 cents. The loss was caused by the holding of commercial paper issued by Lehman Brothers. This is also the second time in the history of money market funds that they have “dropped below the U.S. dollar.”

Panic in the money market fund industry has led to a large number of redemption requests. On the same day, Bank of America (BAC) announced that it would acquire Merrill Lynch, the largest brokerage firm in the United States. In addition, the credit rating of American International Group (AIG), one of the leading financial companies in the United States, was downgraded because the number of credit derivative contracts it underwritten exceeded its ability to pay.

The government began to bail out

On September 18, 2008, rumors about government rescue began, and the Dow Jones Index rose 410 points. The next day, Treasury Secretary Henry Paulson proposed to provide up to $1 trillion in Troubled Asset Relief Program (TARP) to purchase toxic debt to prevent a complete financial collapse.

Also on this day, the U.S. Securities and Exchange Commission (SEC) initiated a temporary injunction prohibiting the short-selling of the stocks of financial companies, believing that this would stabilize the market. Driven by this news, the Dow rose 456 points to an intraday high of 11,483 points, and finally closed 361 points higher to 11,388 points. As the financial market is about to experience three weeks of complete turmoil, these highs will prove to be of historical significance.

Escalation of the financial turmoil

The Dow will drop 3,600 points from its intraday high of 11,483 on September 19, 2008 to its intraday low of 7,882 points on October 10, 2008. The following is a review of major events in the United States during this historic three-week period.

September 21, 2008

Goldman Sachs (GS) and Morgan Stanley (MS) are the last two major investment banks that still exist. They have transformed from investment banks to bank holding companies to gain greater flexibility in obtaining bailout funds.

September 25, 2008

After a 10-day bank run, the Federal Deposit Insurance Corporation (FDIC) confiscated Washington Mutual Bank, the largest savings and lending institution in the United States at the time, and the bank was heavily exposed to the risk of subprime mortgage debt. Its assets are transferred to JPMorgan Chase (JPM).

September 28, 2008

The TARP rescue plan was stranded in Congress.

September 29, 2008

The Dow fell 774 points (6.98%), the largest drop in history.

October 3, 2008

The revised $700 billion TARP plan was renamed the Emergency Economic Stability Act of 2008, and a bipartisan vote was passed in Congress.

October 6, 2008

The Dow closed below 10,000 for the first time since 2004.

October 22, 2008

President Bush announced that he will host a meeting of international financial leaders on November 15, 2008.

Bottom line

Although good intentions may have been the catalyst that led to the decision to expand the subprime mortgage market in 1999, it had many effects and had a negative impact on the economy in 2008.

Considering the growth of the subprime mortgage market and its creatively derived investment tools, coupled with the explosive growth of consumer debt, it is hard to say that the 2008 financial turmoil and the ensuing Great Depression could have been minimized Or if a more financially responsible policy is implemented earlier, it may be avoided.


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