Skip to main content

2008 The Year of Reckoning

“I believe the worst is yet to come,” I wrote. “Why? Because unlike many other corrections (1987, 1997, 1998, 2001 and 2002), this time American homeowners have their biggest assets on the table, their houses.”

– Mark Grimaldi, The Navigator, February 2008.

Despite the confidence of many economists, Americans were scared, and their fears showed up in the world equity markets. January 2008 was particularly volatile, with some members of the news media even referring to January 21 as “Black Monday.”

At this time, the government was insisting we weren’t in a recession. Former Fed Chairman Alan Greenspan, for example, said in January that data showing a recession “is by no means conclusive” because “you don’t gradually fall into recession, you jump.”

Meanwhile, the Fed kept trying. On January 22, it announced a surprise inter-meeting rate cut, this time reducing the discount rate and federal funds rate to 4.00 percent and 3.50 percent, respectively. On its regularly scheduled January 30 meeting, the Fed acted again, reducing the discount rate and federal funds rate to 3.50 percent and 3.00 percent, respectively.

Unfortunately, the Fed’s moves weren’t enough to make financial institutions increase their borrowing from one another. There was still a crisis of confidence, often referred to as “counterparty risk” or default risk. Counterparty risk is a fear that a financial institution will default on their obligations.  As a result of these risk concerns, lending dried up and an unexpected failure shook the global financial system when Bear Stearns collapsed. 

Like many financial firms, Bear Stearns had invested, through its hedge funds, in bundles of subprime mortgages. In July 2007, the firm disclosed that two of its hedge funds had lost nearly all of their value amid a rapid decline in the market for subprime mortgages. To prevent the market crash that it believed would result from Bear Stearns becoming insolvent, in an emergency unscheduled meeting on March 16, the Fed cut the discount rate to 3.25 percent (but left the federal funds rate at 3.00 percent). The policymakers quickly realized that wasn’t enough.  So, just two days later, on March 18, cut the discount rate to 2.50 percent and the federal funds rate to 2.25 percent. Still not enough.  So the Fed next engineered the controversial takeover of Bear Stearns by JPMorgan Chase The U.S. government, i.e., the taxpayers assumed the risk of Bear Stearns’ less liquid assets, i.e., bundles of sub-prime mortgages.

Fed Chairman Ben Bernanke defended the bailout by stating that a Bear Stearns’ bankruptcy could have caused a “chaotic unwinding” of investments across the U.S. markets and thereby threatened the entire U.S. economy. Former Fed Chairman Alan Greenspan criticized the Fed for allowing itself to exceed its mandate of promoting growth and stable prices. His reasoning was 

institutions increase their borrowing from one another. There was still a crisis of confidence, often referred to as “counterparty risk” or default risk. Counterparty risk is a fear that a financial institution will default on their obligations.  As a result of these risk concerns, lending dried up and an unexpected failure shook the global financial system when Bear Stearns collapsed. 

Like many financial firms, Bear Stearns had invested, through its hedge funds, in bundles of subprime mortgages. In July 2007, the firm disclosed that two of its hedge funds had lost nearly all of their value amid a rapid decline in the market for subprime mortgages. To prevent the market crash that it believed would result from Bear Stearns becoming insolvent, in an emergency unscheduled meeting on March 16, the Fed cut the discount rate to 3.25 percent (but left the federal funds rate at 3.00 percent). The policymakers quickly realized that wasn’t enough.  So, just two days later, on March 18, cut the discount rate to 2.50 percent and the federal funds rate to 2.25 percent. Still not enough.  So the Fed next engineered the controversial takeover of Bear Stearns by JPMorgan Chase The U.S. government, i.e., the taxpayers assumed the risk of Bear Stearns’ less liquid assets, i.e., bundles of sub-prime mortgages.

Fed Chairman Ben Bernanke defended the bailout by stating that a Bear Stearns’ bankruptcy could have caused a “chaotic unwinding” of investments across the U.S. markets and thereby threatened the entire U.S. economy. Former Fed Chairman Alan Greenspan criticized the Fed for allowing itself to exceed its mandate of promoting growth and stable prices. His reasoning was that the Fed’s actions would have unintended consequences on the economy as a whole.

Greenspan, it turns out, was on target, as the fallout from the subprime mess had by then started to show up throughout the U.S. economy. Employers were cutting more jobs. Consumers weren’t spending. They couldn’t even repay their loans. By March of 2008, nearly 30 million homeowners, 25 percent of them, were under water— more than four times  the amount that were just five years ago. By the summer of 2008, the situation was dire, and RealtyTrac reported that foreclosure filings rose 48 percent year-over-year in May of 2008, meaning that one in every 483 U.S. households received a foreclosure filing.   A record 9 percent of American homeowners were either behind on their mortgage payments or in foreclosure at the end of June 2008, according to the Mortgage Bankers Association. Moreover, that was only the beginning, since the number of adjustable-rate loans scheduled to reset to higher rates peaked in May and June, pushing more homeowners into default and foreclosure in the third and fourth quarters of 2008.

By this time, even mortgage giants Fannie Mae and Freddie Mac were struggling, and the Fed felt it had no choice but to assist the Treasury Department in preventing their collapse. The multi-part plan to take over Fannie Mae and Freddie Mac and the $5 trillion in home loans they backed was announced on September 7.  It was one of the most sweeping interventions in the financial markets since the Great Depression.