Agarwal    

1  

Akhilesh  Agarwal  

15  November  2015  

A  build  up  to  the  2008  Crisis,  The  Downfall  of  Financial  System  and  the  New  Fear  

The  turbulence  caused  by  Bear  Stearns  that  rocked  global  financial  markets  was  only  surpassed  

on  September  15th,  2008,  when  Lehman  Brothers  came  flaming  down  upon  the  prescient,  ever-­‐

knowing  minds  of  Wall  Street.  Bear  Stearns  started  the  fire;  Lehman  Brothers,  AIG,  Merrill  Lynch  

and  Wachovia  were  just  a  few  of  the  many  financial  institutions  that  burned  together.    

 

Several  businesses,  trillions  of  dollars  of  wealth  and  millions  of  lives  were  destroyed  because  of  

the  gratuity  awarded  to  a  parade  of  financial  engineering  manipulations.  The  social  safety  net  

was  expanded  and  large-­‐scale  fiscal  stimulus  programs  were  enacted  to  combat  the  recession  

caused  by  financial  distress.  [1]  

 

Financial  engineering  gimmicks  were  just  the  prologue  in  the  book  that  led  to  the  collapse  of  the  

global  financial  system  in  2008.  A  cushion  was  created  for  employees  that  were  excessively  risk-­‐

seeking,   through   the   courtesy   of   a   lop-­‐sided   reward   system.   An   array   of   banking   practices,  

especially  through  subprime  mortgages  and  excessive  leverage  employment,  drove  the  financial  

system  into  a  trench.  Soaring  housing  prices  between  the  time  period  of  the  Savings  &  Loan  Crisis  

and  2007  [2];  rating  agencies,  in  conjunction  with  terrible  regulation,  concluded  the  last  chapter  

that  led  to  the  financial  collapse.  

 

Two  of  the  many  protagonists  that  were  precursors  to  the  great  collapse  of  2008  included  the  

bond  bubble  and  the  housing  bubble.  The  housing  bubble  was  rife  with  problems  of  leverage,  lax  

regulation,  unethical  compensation  practices  and  smart  financial  manipulations.  According  to  a  

survey  conducted  by  Case-­‐Shiller,  US  citizens  expected  a  22%  guaranteed  profit  per  year,  which  

was  certainly  unattainable  in  the  stock  market,  on  houses  that  they  bought  with  up  to  five  times’  

leverage.  

 

   Agarwal    

2  

We  have  learnt  from  the  South  Sea  Bubble  and  the  case  of  the  Tulip  Bulbs  in  the  Netherlands,  

that   we   are   unable   to   prevent   asset   price   bubbles.   [3]   Probabilities   of   default   were  

underestimated  due  to  low  risk  spreads  over  Treasuries,  inflating  bond  prices,  which  at  that  time,  

was  an  event  in  synergy  with  the  housing  bubble.    

 

There  was  some  truth  in  the  fact  that  one  could  earn  a  vast  sum  of  money  through  real  estate.  

The  bursting  of  the  Internet  Bubble  in  2000  [4]  deterred  American  citizens  from  investing  in  Silicon  

Valley  and  instead,  they  took  to  safer  investments  in  the  housing  scenario.  Banks  encouraged  the  

US  citizens  by  allowing  them  to  take  out  mortgages  on  new  houses  at  extremely  high  leverage  

ratios.  It  became  too  easy  for  just  about  anyone  to  own  a  home  in  America.  This  was  the  first  

letdown  by  financial  regulators  in  a  series  of  failures.  

 

Houses   became   akin   to   ATMs   as   homeowners   effectively   used   the   spread   between   the  

refinancing  rates  and  their  original  mortgage  to  obtain  larger  mortgages  and  cash.  To  fuel  this  

kindling  fire,  the  Federal  Reserve  held  the  short  term  interest  rates  low  in  2003  and  2004,  marking  

the  observable  beginning  of  the  housing  bubble;  observable  –  in  retrospection.  

 

Tinkering   with   the   pooled   assets   that   formed   the   Mortgage   Backed   Securities   (MBS),   the  

engineers   of   Wall   Street   came   up   with   forms   of   investments   called   ‘Collateralized   Debt  

Obligations’   (CDOs)   that   essentially   grew   the   housing   bubble.   Tranches   that   had   the   least  

credibility,  also  called  ‘toxic  waste’,  were  repackaged  into  whole  new  CDOs  which  had  their  own  

tranches.  Financial  regulators  failed  yet  again.  

 

AIG  oversold  another  marvel  of  financial  engineering  called  Credit  Default  Swaps  (CDS),  which  

was  a  novel  insurance  tool,  posing  as  a  derivative,  created  to  pay  the  holders  of  debt  instruments  

on  default.  The  default  rates  were  low  which  brought  about  a  feeling  of  false  security  to  insurers  

such  as  AIG.  Despite  all  the  warning  signs,  the  risk  in  the  AIG  derivatives  portfolio  was  exorbitant  

and  no  one  expected  the  chain  reaction  that  eventually  led  to  the  financial  crisis.  [5]    

 

   Agarwal    

3  

Prevention  of  market  collapses,  minimization  of  costs  to  taxpayers  and  limitation  of  contagion  

from   one   sick   institution   to   another   are   the   main   roles   of   financial   regulators.   The   Federal  

Reserve,  the  Office  of  the  Comptroller  of  the  Currency,  the  Office  of  Thrift  Supervision  and  the  

Federal  Deposit  Insurance  Corporation  were  the  regulatory  watchdogs  during  the  period  of  the  

crisis   and   the   years   leading   up   to   it.   Some  of   the   appalling   underwriting   practices   that  were  

rampant  during  the  time  could  have  been  abolished  with  the  combined  power  of  these  regulatory  

bodies,  but  they  weren’t.  

 

There  was  a  plethora  of  warning  signs  as  the  enormous  growth  in  lending  rung  no  bells  within  

the  regulatory  system.  Media  reports  that  spoke  about  risky  lending  practices  in  the  subprime  

mortgage   sector  were   frequent.  Edward  Gramlich  warned  Alan  Greenspan   in  2000  about   the  

imminent  crisis.  The  OCC,  FDIC,  OTS  and  the  Federal  Reserve  announced  that  they  were  getting  

around  to  cracking  down  on  the  disgraceful  subprime  lending  practices,  which  they  never  did.  

 

Two  of  the  most  influential  people  of  the  time,  Hank  Paulson,  Secretary  of  the  Treasury  and  Ben  

Bernanke,  Chairman  of  the  Federal  Reserve  were  confident  that  the  problems  in  the  subprime  

mortgage  sector  were  isolated  and  would  not  contaminate  the  rest  of  the  financial  system.  

 

The  roots  of  the  financial  crisis  can  be  traced  back  to  the  Federal  Reserve’s  decision  of  lowering  

interest  rates,  leading  to  massive  misallocation  of  resources  and  a  distorted  capital  structure.  [6]  

To  fight  this  economic  downturn,  the  Federal  Reserve  announced  two  new  liquidity-­‐providing  

facilities  on  December  12,  2007.  Currency  swaps  with  foreign  central  banks  and  Term  Auction  

Facilities   were   introduced.   Walter   Bagehot,   a   British   journalist   from   the   mid   19th   century,  

believed  that  during  times  of  financial  crises,  the  central  bank  ought  to  lend  freely,  against  good  

security  but  at  high  interest  rates.  According  to  Bagehot,  “the  way  to  cause  alarm  is  to  refuse  

some  one  who  has  good  security  to  offer.”  [7]  This  principle  was  the  basis  of  the  Term  Auction  

Facility.    

 

   Agarwal    

4  

The  Federal  Open  Market  Committee  (FOMC)  faced  two  major  problems  –  a  provision  for  massive  

amounts   of   liquidity   was   required   and   interest   rates   needed   to   be   cut   to   fight   the   looming  

recession.    A  mixture  of  Keynesian  Economics  [8]  and  Bagehot’s  Principle  had  to  be  adopted  to  

save  the  economy  from  the  downward  spiral  the  subprime  mortgage  business  drove  it  into.    

 

A  big  player  in  the  mortgage  business  was  Bear  Stearns.  Between  the  years  2000  and  2008,  the  

top  five  in  the  management  team  took  home  $1.4  billion  in  stock  sales  and  in  cash,  credited  to  

the  reward  system  at  the  company  –  a  clear  failure  of  the  board.  Bear  made  enemies  by  refusing  

to  buyout  its  share  of  the  Long-­‐Term  Capital  Management  (LTCM)  during  the  peak  of  the  1998  

financial  crisis,   leaving  a  bitter  aftertaste  which  Wall  Street  remembered  in  March  2008.  Bear  

was  considered  the  weakest  in  the  ‘Bulge  Bracket’  and  by  the  end  of  2007  it  was  borrowing  over  

$100  billion  in  overnight  repos.  To  counter  the  fall  of  Bear  Stearns,  the  Federal  Reserve  invoked  

a  clause  of  the  FRA,  Section  13(3)  –  which  has  now  been  amended  by  the  Dodd-­‐Frank  Act.  The  

clause  allowed  the  supermajority  of  five  of  the  seven  governors  to  make  emergency  loans  in  a  

state  of  emergency.   In  March  2008,  JP  Morgan  Chase  announced  that   it  would  purchase  Bear  

Stearns,  with  the  Federal  Reserve  putting  its  own  money  at  stake.  

 

Lehman  Brothers  was  the  next  company  that  fell  victim  to  the  contagion  of  2007  and  2008.  AIG  

had  to  be  nationalized  to  salvage  billions  of  dollars  in  wealth,  the  second  major  instance  when  

the  Federal  Reserve  invoked  the  Section  13  (3)  clause  to  pump  in  $85  billion  to  AIG.  The  Federal  

Reserve  could  have  invoked  the  same  clause  to  save  Lehman  as  they  did  with  Bear  and  AIG,  as  

the  Federal  Reserve  did  not  require  a  congressional  approach.  It  was  authorized  by  Section  13  (3)  

of  the  FRA  to   lend  to  anyone;  dicey  mortgages  of  Bear  Stearns  were  accepted  on  March  14th,  

questioning  the  ‘good  collateral’  doctrine  of  Bagehot’s  principle  but  Lehman  was  given  no  loan.    

 

The  Federal  Reserve  and  the  Treasury  sought  damage  control  when  it  became  apparent  that  the  

subprime  disease  had  spread  out  too  far  and  wide.  $50  billion  was  given  to  the  insurance  fund  

for  money  market  balances  from  the  Exchange  Stabilization  Fund  (ESF).  This  was  the  first  instance  

of  the  US  Treasury  putting  its  own  money  at  stake.  This  was  another  case  of  bending  the  law  to  

   Agarwal    

5  

meet   unexplained   needs   –   If   the   Treasury   was   allowed   to   use   the   ESF,   it   should   have   been  

perfectly  legitimate  for  the  Federal  Reserve  to  loan  out  emergency  funds  to  save  Lehman,  or  to  

at  least,  have  been  allowed  the  use  of  the  ESF  for  Lehman.    

 

Ben  Bernanke  considered  the  three  options  that  he  was  left  with  to  save  what  was  left  of  the  

once  strong  and  mighty  financial  system.  The  Federal  Reserve  could  lower  the  federal  funds  rate,  

beyond  1%,  with  the  help  of  the  FOMC.  The  FOMC  could  also  hold  its  overnight  rate  low,  allowing  

for  a  reduction  in  long  term  interest  rates  and  the  Federal  Reserve  could  acquire  more  financial  

institutions   to   save   them   from   defaulting   –   the   Fed’s   balance   sheet   read   $2,262   billion   on  

December  11,  up  from  $924  billion  a  week  before.  The  new  monetary  policy  was  a  combination  

of  all  of  these  recommendations.  The  FOMC  started  the  expansion  of  its  balance  sheet,  lowered  

the  federal  funds  rate  below  25  basis  points  and  announced  that  long  term  interest  rates  would  

be  maintained  close  to  0.    

 

The  Federal  Reserve  should  have   injected  capital  directly   into  banks  by  buying   their  common  

stock,   as   George   Soros,   Paul   Krugman   and   Joe   Stiglitz   suggested,   and   as   Federal   Reserve  

Chairman,  Bernanke  intended.  Holding  the  interest  rates  at  lower  than  1%  percent  was  a  good  

decision  by  the  FOMC,  but  the  announcement  of  its  long  term  maintenance  allowed  for  a  skewed  

precedence  to  be  set.    The  Federal  Reserve  created  the  Asset  Backed  Commercial  Paper  Money  

Market  Mutual  Fund  Liquidity  Facility  (AMFL)  to  buy  asset  backed  commercial  paper  from  money  

market  funds.  This  move  was  made  to  provide  liquidity  to  banks  at  low  interest  rates.  In  short,  

the  Federal  Reserve  floored  interest  rates,  creating  a  massive  amount  of  liquidity  and  purchased  

assets   to   expand   its   balance   sheet   and   issued   guarantees   that   would   have   previously   been  

considered  unimaginable  

 

Meanwhile,  the  Treasury  had  enlisted  the  aid  of  Philip  Swagel  and  Neel  Kashkari  to  set  up  the  

Troubled  Assets  Relief  Program  (TARP).  The  TARP,  also  called  the  Paulson  Plan,  was  introduced  

to  buy  toxic  assets,  guarantee  assets  and  refinance  home  mortgages  into  loans.  As  a  provision  of  

the  TARP,  Hank  Paulson  was  given  $700  billion  to  buy  failing  assets,  mainly  those  of  Freddie  Mac  

   Agarwal    

6  

and  Fannie  Mae.  The  TARP,  despite   its  weaknesses,  kept  the  economy  afloat  and  rescued  the  

banking  and  auto  industry.    

 

On   the  whole,   certain   practices   that   led   to   the   downfall   in   2008   have   been   scrutinized,   and  

various   laws   have   been   enforced   to   prevent   a   disaster   of   this  magnitude   in   the   future.   The  

Financial  Stability  Oversight  Council  (FSOC)  was  created  as  a  part  of  the  Dodd-­‐Frank  Act.  The  main  

role  of  the  FSOC  is  to  properly  scrutinize  the  operations  of  financial  institutions  that  have  been  

deemed  “too  big  to  fail”  and  “too  interconnected  to  fail”.  Executive  compensation  came  under  

scrutiny  with   the   introduction  of   the  Dodd-­‐Frank  Act,   compensation   is   to  be  set  according   to  

regulatory   guidelines   and   companies   are   to   have   independent   compensation   committees.  

Regulations  on  trading  in  the  derivatives  market  has  been  imposed  by  the  Volcker  Rule.  Predatory  

mortgage   lending   has   been   banned   by   the   Consumer   Financial   Protection   Bureau   (CFPB).  

According  to  the  Treasury  Proposal  in  2009,  the  OTS  and  the  OCC  were  merged  into  one  entity  

and   the   Securities   and   Exchange   Commission   (SEC)   and   Commodities   Futures   Trading  

Commission  (CFTC)  were  to  remain  separate.  [9]  

 

All   said  and  done,   the   fact   remains   that   the  key   interest   rate   today   is  close  to  0.  The  Federal  

Reserve  cut  interest  rates  from  close  to  5.25%  by  the  end  of  2007  to  0.25%  by  the  start  of  2009,  

a  5%  drop  in  almost  15  months.  There  is  enough  reason  to  believe  that  in  case  a  financial  crisis  

hits  us  again,  the  Federal  Reserve  does  not  have  its  most  significant  weapon,  locked  and  loaded.  

There  is  also  enough  reason  to  believe  that  there  might  be  another  crisis  soon  –  a  second  bubble  

in  the  technology  industry  is  growing,  with  companies  in  Silicon  Valley  being  over-­‐valued  causing  

the  value  of  each  additional  successful  startup  to  rise,  synonymous  to  the  snowball  effect.  CDOs  

are   being   brought   back   into   the   market   with   StoneCastle   Financial   being   just   one   of   the  

companies   behind   this   operation.   The   advent   of   CDOs  will   give   rise   to   the   ‘shadow  banking’  

system  once  again  as  financial  engineers  will  work  around  existing  laws  to  build  new  investment  

vehicles.    

 

   Agarwal    

7  

The   financial   system  today   is  stronger   than  before  with  banks  having  built  up  capital  and  the  

government  having  filled  in  certain  regulatory  holes.  [10]  But  the  next  crisis  will  not  be  exactly  the  

same  as  the  Great  Depression  of  1929  or  the  Financial  Crisis  of  2008.  The  fear  now  is  that  all  new  

laws  that  have  been  enacted  might  be  too  focused  on  resolving  specific  issues  that  should  have  

been  dealt  with  back  during  the  early  2000s.  The  looming  crisis  will  bring  about  its  own  set  of  

problems.  More  capital  needs  to  be  accumulated  for  the  respective  bodies  to  fall  back  upon  to  

use  Keynesian  theories  effectively.    

 

Citations:  

[1]  Michael  Lewis.  The  Big  Short:  Inside  the  Doomsday  Machine.  February  2011.  Print  

[2]  Kathleen  Day.  S  &  L  Hell:  The  People  and  the  Politics  Behind  the  $1  Trillion  Savings  and  Loan  

Scandal.  May  1993.  Web  

[3]  John  Kenneth  Galbraith.  A  Short  History  of  Financial  Euphoria.  July  1994.  Print  

[4]  Anthony  B.  Perkins.  The  Internet  Bubble.  September  2001.  Print  

[5]  David  Paul.  Credit  Default  Swaps,  the  Collapse  of  AIG  and  Addressing  the  Crisis  of  Confidence.  

May  2011.  Web  

[6]  Thomas  E.  Woods  Jr.  Meltdown.  February  2009.  Print  

[7]  Walter  Bagehot.  Lombard  Street:  A  Description  of  the  Money  Market.  April  1999.  Web  

[8]  Akhilesh  Agarwal.  The  Real  Conflict  of   the  Great  Depression,   Interwar  Years  and   the  2008  

Crisis.  October  2015.  Print  

[9]  Alan  S.  Blinder.  After  The  Music  Stopped:  The  Financial  Crisis,  The  Response,  and  the  Work  

Ahead.  October  2013.  Print  

[10]  Clive  Crook.  What  if  the  2008  Crisis  Comes  Around  Again?  August  2015.  Web