By Rowland Goddard, Staff Writer
The financial crisis of 2008 highlighted that any economy is susceptible to a crash. Prior to the crisis, most Americans believed in the strength of the economy as they pursued the “American Dream.” Little did they know, in the background, poor financial decisions were being made that would affect the whole country in the coming years. This economic crash would cause many people to lose everything they had.
Lead Up to the Crisis:
The crisis was the result of years of unwise financial decisions made in both the public and private sectors. Although many people were quick to place the blame on the Banks, in my opinion, it was the structuring of the American financial system that resulted in the crisis. The lack of financial regulation allowed banks and the American people to make investments that were too good to be true. It began with years of rock-bottom interest rates and loose lending rules allowing a housing bubble to form. This happened shortly after the September 11th terrorist attacks. To stimulate growth, the Fed’s lowered the Federal Funds Rate from 6.5% to 1%. Lower rates incentivized lending in the form of mortgages, causing home prices to rise. To make matters worse, subprime borrowers – borrowers who had poor credit history – were able to purchase houses out of their price range. The tandem of low-interest rates and loose borrowing regulations catapulted housing prices.
Banks that held these subprime mortgages, such as Fannie Mae and Freddie Mac, sold them to the Wall Street financial banks, which then packaged them into low-risk financial instruments such as mortgage-backed securities and collateralized debt obligations (CDOs). Although they were advertised as low risk, this was not the case as these packages included loans with subprime borrowers. Making matters worse, in 2004, the Securities and Exchange Commission (SEC) relaxed net capital requirements for the five large banks. This meant these banks could hold less money, transferring it into investments. This gave the banks the ability to leverage their initial investments by up to 30-40 times more.
Signs of distress were evident years before the eventual collapse of the economy. In 2004, homeownership in the U.S. peaked at 69.2% because of lower interest rates. However, by 2006, the market had become saturated and housing prices started to fall. Eventually, the prices of homes became less than what owners originally paid. Subprime borrowers were stuck with their mortgages that they couldn’t afford in the first place. Without the ability to pay back their mortgages, the banks claimed their now worthless homes.
Outcomes in America:
By early 2008, the U.S. economy was in a recession, forcing the Federal Reserve System to cut its benchmark rate by three-quarters of a percentage point – the biggest cut in a quarter of a century. In June of that same year, the unbelievable happened, the banks started to fail. America’s two biggest home lenders, Fannie Mae, and Freddie Mac had been seized by the government. Shortly thereafter, the Lehman Brothers collapsed, marking the biggest bankruptcy in U.S. history. Financial markets were in free fall, with indexes experiencing extreme losses. At this point, confidence in the U.S. financial system was at an all-time low.
To stop the bleeding, the government had to bail out the banks and purchase a huge number of toxic assets. Total government bails equated to $1,488 Billion (Bear Stearns $30B, Fannie and Freddie $187B, APPRA Tax Cuts and Spending $831B, TARP Bank $440B). The Troubled Asset Relief Program (TARP) was the government buying back toxic assets such as subprime loans. This ended up costing the American taxpayers $73 Billion.
The damage of the crisis was evident across the country. 5.5 million Americans lost their jobs due to slower economic growth during the recession. During the period July 2008 to March 2009, stock values lost $7.4 trillion in wealth and home values lost $3.4 trillion in real estate value. A 2018 study by the Federal Reserve Board found that the crisis cost every single American approximately $70,000.
Outcomes in Canada:
The Canadian financial system was more firmly regulated than the American, so the collapse wasn’t as severe. Canada had set up a concentrated banking system that controlled mortgage lending and investment banking under the watchful eye of a single regulator. Canada had only 80 banks compared to the USA’s 7000. This meant the Canadian financial system was more centralized. Additionally, Canada’s regulatory cap on leverage at an asset-to-capital ratio was 20-1. As a result, major Canadian Banks had an average asset-to-capital ratio of 18 in 2008. In comparison, in the US system, the ratio was 25.
Nevertheless, there were still serious implications in the Canadian economy. In October 2008, the Bank of Canada was forced to reduce its target overnight rate from 3% to 2.5%. This was then followed by further rate cuts until bank policy rates were reduced to 0.25 percent. Interestingly, the Bank of Canada did not engage in quantitative easings as the US and UK did. Prior to the crisis, the Canadian dollar had been trading at par with the American. By March 2009, the Canadian dollar had depreciated by more than 20 percent to less than US$0.80. Similar consequences to the crisis, such as loss of jobs and investment health were seen in Canada, but at a lower magnitude.