What Caused the Market Crash of 2008?

Abstract

The 2008 stock market crash was mainly caused by the subprime mortgage crisis that led to massive Federal Reserve intervention, investor anxiety, widespread loss of jobs, and collapse of large banks and financial institutions. Banks issued loans to people with bad credit ratings hoping that they would retrieve their money by foreclosing on the homes of borrowers in case they failed to repay.

The housing market was perfuming well and homes were considered good assets that could be bought and sold to make a profit. Housing prices plummeted, and as a result, the credit market weakened. Banks collapsed because they had exhausted their money reserves by issuing loans beyond their capabilities. The collapse of several financial institutions affected the stock market as investors hastily sold their shares to avoid losses. The US implemented trading curbs as a mitigation strategy to prevent future crashes. Trading curbs comprise three thresholds that lead to temporary closure of the stock market in case any one of them is breached.

Introduction

September 16, 2008 went down as one of the most critical days in the financial history of the United States and the world. On that eventful day, several financial institutions in the United States failed and orchestrated the crash of the stock market. The failure was primarily due to unsecured mortgages and loans issued by banks. Moreover, exposure of credit default swaps that were aimed at insuring the loans led to a sharp reduction of stock prices on major financial markets around the globe.

The failure of banks in the United States, Europe, and Iceland caused a global financial crisis that led to closure of markets temporarily. For example, in Iceland, it caused massive devaluation of the currency. In the US, the stock market depreciated in value by 21%. The depreciation continued with the Dow Jones losing by 18% and stock exchange indexes by 10% (Garnaut & Llewellyn-Smith, 2009). The UK stock markets were also severely affected because they lost 30% of the FTSE 100 within a month.

In this paper, I will respond to the research question: what caused the stock market crash of 2008 and what has been done about it? I will show that the stock market crash was primarily caused by the subprime mortgage crisis in the US that led to the collapse of major banks and financial institutions, which compelled the Federal Reserve to reduce interest rates to negative levels and spend billions of dollars in bailout efforts.

Causes of the stock market crash

The stock market crash was primarily caused by the subprime mortgage crisis experienced in the US that resulted in the collapse of several banks and financial institutions (Garnaut & Llewellyn-Smith, 2009). Financial institutions issued loans without evaluating the credit scores of borrowers. As a result, many people with bad credit ratings took massive loans even though they did not have the means to repay them (Spiegel, 2011).

Lenders were giving more money that they had in their reserves. The housing market was growing rapidly and home prices were rising. The rising prices encouraged banks and financial institutions to carry on with their poor lending practices. Lenders were not worried about borrowers with bad credit rating because in case they defaulted on their loans, they would foreclose on their homes (Shinkle, 2008).

They assumed that they would not lose money because home prices were rising and demand was high. In 2007, housing prices began to plummet and caused a lot of anxiety in the credit market. Homeowners were in financial turmoil because their loans exceeded the value of the homes they had bought (Spiegel, 2011). As a result, they welcomed the idea of foreclosure because their homes were no longer assets but liabilities.

The plummeting of housing prices led to massive rise in mortgage defaults that increased anxiety in the credit markets (Shinkle, 2008). The economy was also starting to weaken and the destabilization of the credit market had spread to the national financial system. There was widespread fear among lenders that borrowers would not repay their loans and foreclosing on their homes would not help them recover their money since housing prices were falling (Shinkle, 2008).

These unsecured loans presented challenges to banks because the majority of borrowers could not repay them. News of a looming financial crisis and the possible collapse of banks caused anxiety among investors who were afraid of losing their investments. They chose to sell the shares they had invested in banks and get out of the stock market before the crisis. As a result, massive sale of bank shares caused a snowball effect in the stock market that led to substantial depreciation of stock prices (Shinkle, 2008).

Bear Stearns was the first investment bank to suffer the effects of the weakening credit market (Spiegel, 2011). Investors and financial institutions began to withdraw their money from the bank, and as a result, affected its liquidity position. The bank announced that it would file for bankruptcy. However, it was saved by a merger with JP Morgan that salvaged only 10% of its market value (Garnaut & Llewellyn-Smith, 2009).

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) owned many mortgage loans that could not be repaid. Both corporations were showing signs of financial distress because their combined mortgage loans of $6 trillion were putting great pressure on them (Clarke, 2015). Continued financial strain compelled the Federal Housing Finance Agency (FHFA) to place the two agencies under the management of a conservator (Spiegel, 2011). The United States Treasury Department mitigated the problem by giving both agencies money to revamp their operations. This move had severe financial effects because it raised the national debt by $800 billion and weakened the national financial system more (Spiegel, 2011).

By late 2008, financial volatility was on the rise and concerns over the ability of financial institutions to address their financial constraints caused further instability in the market. Lehman Brothers declared bankruptcy, the Dow continued to drop, and the Federal Reserve gave a $85 billion loan to AIG (Garnaut & Llewellyn-Smith, 2009). AIG had exhausted its money reserves paying off credit default swaps that had been issued during the subprime mortgage lending boom. Increased panic among investors pushed money market funds downwards and the Dow continued to plummet.

Fall of the Dow JIA during the market crash.
Figure 1: fall of the Dow JIA during the market crash (Garnaut & Llewellyn-Smith, 2009).

The greatest fall of the Dow occurred on September 20 after Congress rejected a $700 billion bailout strategy proposed by Hank Paulson and Ben Bernanke (Spiegel, 2011). It fell 777.68 points and the passage of the bailout package in October by Congress did not mitigate the problem (Garnaut & Llewellyn-Smith, 2009). News of massive job losses from the Labor Department caused the Dow to drop 800 points.

The Federal Reserve was committed to address the banking liquidity crisis that was threatening to bring the American economy down. The market funds received a loan of $540 billion and Fed funds rate was lowered to 1% (Clarke, 2015). Throughout the month of October, the Dow went down by 13% in response to intervention moves by the Federal Reserve (Spiegel, 2011).

Aftermath and mitigation strategies

The collapse of the stock market affected the US economy severely. Therefore, the government decided to bail out banks and other financial institutions by giving them money so that they could continue their operations (Clarke, 2015). An important mitigation measure the government took was to temporarily ban stock shorting in financial companies (Spiegel, 2011). Stock shorting refers to the trading strategy of buying stocks when prices are low and selling them when they appreciate in value.

The practice allows investors to make money when the stock market is depreciating or when companies are collapsing. The government also adjusted interest rates downwards to encourage the creation of new businesses (Shinkle, 2008). These measures were not effective because the US economy was going into recession.

An effective mitigation strategy that was implemented by several governments was the introduction of trading curbs to prevent occurrence of another stock market crash. Also known as circuit breakers, the main role of trading curbs is to prevent speculative gains and massive loses within short periods of trading in the market (Guynn & Polk, 2010). In the United States, trading curbs comprise three thresholds that protect the market from crashing. When any of these thresholds is breached, trading is stopped and the market is closed for a certain period of time. These thresholds are aimed at halting stock trading when signs of a potential crash are identified in order to prevent a surge of anxiety among investors (Guynn & Polk, 2010).

Each of the three thresholds is computed to react to the movement of the Dow Jones Industrial Average. They are calculated at the end of each quarter and apply in the stock market based on time and the type of breach that occurs. In France, a different strategy was implemented. Price limits in the cash and derivatives markets are set at the start of every day and there is a specific deviation from the quoted price that stops trading for a certain period (Guynn & Polk, 2010).

Conclusion

The 2008 stock market crash had severe financial consequences because it caused a recession that affected the global economy. Several factors such as investor anxiety, weakening of the credit market, and massive Federal Reserve intervention contributed to the crash. However, it was primarily caused by the subprime mortgage crisis that led to the collapse of big banks and financial institutions that weakened the economy and the national financial system.

The stock market crash was a financial phenomenon that had severe effects such as loss of jobs, collapse of financial institutions, rising of the national debt ceiling, and a severe recession. Several mitigation strategies were put in place to prevent the occurrence of such an event in future. Their success is largely determined by proper implementation. The Dow Jones has exhibited an upward trend since the crash and it is highly unlikely that another crash as severe as that of 2008 will occur soon. Stock prices might plummet but the aforementioned mitigation strategies will close the market when certain thresholds are breached to avoid a crash.

References

Clarke, T. (2015). 2008 Stock Market Crash Causes and Aftermath. Web.

Garnaut, R., & Llewellyn-Smith, D. (2009). The Great Crash of 2008. New York, NY: Melbourne University Publishing.

Guynn, R., & Polk, D. (2010). The Financial Panic of 2008 and Financial Regulatory Reform. Web.

Shinkle, K. (2008). The Crash of 2008: How Bad is it, and when Will it End? Web.

Spiegel, M. (2011). The Academic Analysis of the 2008 Financial Analysis. Review of Financial Studies 24(60, 1773-1781.

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