Summary of Origins of Financial Crisis 2008

History on Current Financial Crisis

The United States is operating on a fractional reserve banking system, just like in the 1830s.^[1]

Money supply is controlled by the Federal Reserve Board.
Most money is held in the form of checking account deposits, rather than bank notes (a liability to banks that issued them) and coins, and there is amoney multiplier.
The reserve ratio of member banks of the Federal Reserve system is regulated.
Deposits are insured by the FDIC, so banks runs have virtually been eliminated.

Banks and thrift institutions make mortgages, loans with a piece of real estate as collateral. Mortgages can be sold on a secondary market.
- Corporations such as Freddie Mac and Fannie Mae were set up in the 1930s to create a secondary market in mortgages. They would buy mortgages from the banks, then package multiple mortgages and sell them to other lenders, these packages are called, “mortgage backed securities.”
- The root of the current financial crisis were “mortgage backed securities.” Bundles of “mortgage backed securities” were known as Collateralized debt obligations were also placed on the market.^[1]

Along with low interest rates and rising house prices, banks and other lenders began making loans to riskier borrowers and requiring less equity from borrowers. The “risk” of these loans could be diversified by bundling many loans in the “mortgage backed securities.”^[2]

When housing prices began falling the summer of 2007, lenders worried about the credit worthiness of the loans in the bundles they held.
- As people began worrying about the credibility of the mortgage backed securities, the price of those bonds fell and interest rates rose. Individuals and institutions who held these bonds thought it was easy to liquidate, but found that they could do so at a loss. Further selling only depressed the price more.
- This was what happened in 1837 and 1839 as banks simultaneously tried to convert bills of exchange and their assets into cash.^[1]

Investment banks including banks and mortgage lenders were more involved in the creation of the “mortgage crisis securities.” Many investment banks retained some interest in these assets because they were also involved in debt servicing.
- In the summer of 2007, the investment banks were under pressure, and their attempts to obtain liquidity by selling assets made the crisis worse.^[2]

A new kind of financial instrument, the Credit Default Swap, played a major role in the crisis in 2008. This new instrument is an insurance policy against bond default. Just like “mortgage backed securities”, the assets being traded were not uniform, nor was the prices of these assets was visible to all the traders.^[2]

When investment banks and insurance companies such as AIG had large positions in Credit Default Swap, came under pressure, and the bond prices started falling. Some Credit Default Swaps required the insurer to make partial compensation to the policy owners.^[2]

The uncertainty over the net position and liabilities of the investment banks brought several of them down. The buyers had the incentives to understand the risk of the underlying assets, but was caught up in the bubble mentality, others saw large profits and wanted to get in on the action.^[2]

↑ ^1.0 ^1.1 ^1.2 University of Maryland’s economics professor John J. Wallis’ page on [Current Financial Crisis.
↑ ^2.0 ^2.1 ^2.2 ^2.3 ^2.4 Brookings Institute’s page on Origins of Crisis.

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