Economic Crisis Paper

Hailu Bogale

Economic Crisis Paper

The Wall Street meltdown of 2008 showed signs on February 27th 2007 with a 9 percent fall in the Shanghai market; followed by a 416-point slide in the Dow; (Krugman) however it did not come into critical thinking until things start to get out of hands. There were multiple causes that catalyzed that foresaw the meltdown. Stocks began to break down, and banking companies filed for bankruptcy. Additionally, people were laid off, which caused them to search for new jobs due to the Wall Street's Meltdown. Interest rates dropped in mortgage; therefore many people were refinancing their homes and buying new houses, trying to take advantage of the lowered interest rates of the mortgages that the banks had apparently offered. What they didn't know was that their banks had a surprise for them. The Federal Government then had devised a plan to help companies back on their feet: this was delivered as a $700 billion bailout plan. Where did this meltdown root from, and how did the Federal Government's act upon this with a $700 billion bailout plan?

Finding the source of the Meltdown would mean looking back to the late 1990's, where a similar "Boom-and-Bust" had happened: the Tech Bubble of 1990. In this event, Dot-Com internet companies such as Ebay, Google, AOL, Yahoo, etc… have share holders who lost tons of money as stated in the article, "Will dotcom bubble burst again?" reading:

"The current run-up does differ from the implosion that began in 2000 and, within two years, wiped out $5 trillion in paper wealth on Nasdaq, the exchange on which many of these companies were traded. Nasdaq peaked at $6.7 trillion in March 2000 then plummeted to $1.6 trillion by October 2002. (It has since recovered to $3.6 trillion.)"

The National Association of Securities Dealers Automated Quotation System (Nasdaq) (dictionary.com) is the world's fourth largest stock market trader. Fortunately, the first three months of 2006, venture investors funded 761 deals worth around $5.6 billion. This statistic is a 12 percent increase from the same period in 2005 and the highest first quarter since 2002. But in turns of that, the Federal Reserve had to sharply lower interest rates, which led to the Housing Bubble Crash.

Contributing to the meltdown, the Housing Bubble Crash was referred to as "a vicious cycle," and was explained in the article, "Causes and effects of the U.S. financial crisis of 2008: From Wall Street to Main Street,":

"Like the classic play, ‘Other People's Money,' the system is based on using borrowed money (home mortgages) as collateral to borrow more money (mortgage-backed securities), to borrow yet more money (collateralized debt obligations) and hoping the flow of payments remains consistent. When defaults on home mortgages rise, the whole system can unravel.

Traditionally, housing prices tracked inflation, but a decade ago, prices began rising at an unprecedented rate. This boom created wealth, both paper and real. When the upward movement of housing prices slowed and interest rates moved higher, monthly mortgage payments increased substantially, often beyond the borrower's ability to meet those payments. Subprime borrowers (and others) were vulnerable because they couldn't sell or refinance when they owed more than their house is worth.

Normally, banks would foreclose but today most banks bundle their loans and sell them as mortgage-backed securities. The new holder of these mortgages can use them as collateral to issue bonds or finance deals with the interest payments from homeowners covering the interest payment on those bonds.

When homeowners can't make mortgage payments and bond issuers can't pay off the bonds the cycle falls apart. As the bonds lose value companies that borrowed money to buy them must either put up more collateral or sell them, which can cause them to lose even more value. Banks then tighten credit requirements, raising the cost of financing deals and the cost of capital for other businesses. In today's global markets, stock prices drop and bond prices rise around the world. Amid this credit tightening fewer consumers qualify for mortgages further depressing the housing market and perpetuating this downward cycle."

From this source, it suggests that the interest rates were dropped by the Federal Reserve. Thus making mortgage payments cheaper which allowed the demand for homes to rise, thus in turn sent prices upward. As a chain of effect, millions of homeowners took advantage of the rate drop to refinance their existing mortgages. When home buyers had to leverage themselves to the hilt to make a purchase, default and delinquency rates began to rise in 2006, but the pace of lending