Financial Crisis of 2008
The Financial Crisis of 2008, or what is commonly known as the precursor of The Great Recession, had its roots in the low interest rates that persisted starting in the early 2000s. While most accounts blame greedy bankers, the source of the problems had several sources.
The build-up in low quality credit as financial institutions relaxed their lending standards. Sub-prime mortgages became a huge piece of the mortgage industry. Predatory lending also played a role. And don’t forget the mortgage purchasers, aggregators and investment bankers who concocted financial products that had high yields but magically low risk. All of these factors were made possible by low rates, or ‘cheap money’.
Like a house of cards, things started to fall down when the Federal Reserve began to raise interest rates in 2005. Up until that point, it seemed that stock prices would keep rising, housing prices would continue their upward trajectory towards infinity. Every player in the stock market and the real estate market, whether beginner or seasoned veteran, was making money. As is often the case when asset prices climb sharply, the Fed starts to think about whether an asset bubble is forming, and how long it will be before it bursts. Many would like to blame the Fed for ‘taking away the punchbowl just as the party was getting started’, but in reality, interest rates that low were unsustainable.
So why were low interest rates a problem? What happens when rates are low is that investors that are used to making more money from their investments begin to look for other products to keep their returns high. Generally, a low interest rate denotes a low risk investment. In order to achieve the same kind of return in a low rate environment, investors begin to look at riskier investments. If AAA rated bonds are only returning say 3%, and the desired yield is 6%, investors relax their standards. The longer rates are kept low, the more frantic the search for yield becomes.
Technology advancements and the exponential growth of the internet lulled many policy makers, including the Fed chairman Alan Greenspan who presided over the first internet boom in the early 2000s, into thinking that this time things were different. The business cycle had been tamed. Productivity had reached a new plateau.
We understand that there were many participants involved in the creation of the crisis, but who was really to blame? Was it the greed of the financial institutions? Did the Fed act quickly enough? Did the Obama administration do all it could? Could all of this pain have been avoided?
Looking back with 20/20 hindsight, we can see that perhaps more could have been done. Perhaps Lehman Brothers should have been rescued along with the other banks. The damage wrought by allowing the bank to fail was much more widespread than anticipated.
Maybe Bear Stearns should have been saved as well.
The fact is we’ll never know how things would have turned out if other actions had been taken. What we do know is this: the Fed lowered rates 6 times in the six months between mid 2007 and March of 2008. They subsequently instituted Quantitative Easing, known as QE1 and QE2. The President along with Congress passed the American Recovery and Reinvestment Act of 2009 in February of that year. The economy has bounced back, job growth is strong - the economy added 257,000 jobs in January 2015 - and the housing market has recovered.