My point of view in what happened back in 2008

1. THE COLLAPSE OF THE U.S. FINANCIAL SYSTEM IN 2008 1
The Collapse of the U.S. Financial System in 2008

2. THE COLLAPSE OF THE U.S. FINANCIAL SYSTEM IN 2008
Abstract
The collapse of the U.S. financial system in 2008 had numerous indicators and precedents.
According to Reuters, between January and September 2008, the emerging stock index in
the market lost 55 percent of its value and developed markets lost 42 percent (Ngassam,
2013). The S&P 500 lost 50 percent of its value from the peak in October, 2007. It was the
most catastrophic market since the 1930s. 7.3 million American homeowners defaulted on
mortgages from 2008 to 2010. 4.3 million of these lost their homes. As of the third quarter
of 2008, one-fifth of American homes were underwater—with negative equity on their
mortgages. Home ownership increased in a quantum curve between 1994 and 2004,
reaching 69 percent. Housing prices increased 124% between 1997 and 2006. This bubble
resulted in a large round of refinancings and second mortgages. US household debt as a
percent of annual disposable income rose to 127% in 2007 versus only 77% in 1990. This
credit and housing price boom led to a surplus of empty homes, sitting unsold on the market.
Many consumers opted for floating-rate debt, which later became a poor choice since
interest rates were bound to rise. After the initial one to three-year term, interest rates went
to market. Many homeowners could not refinance at that time with reasonable rates of
interest commensurate with their income levels. By fall 2008, a decrease in home values by
over 20% from their mid-2006 peak was in place. The U.S. and the world suffered major
consequences in their equity and debt markets, and borrowings on the order of trillions of
dollars followed.
Keywords: financial, system, 2008, collapse, mortgages
2

3. THE COLLAPSE OF THE U.S. FINANCIAL SYSTEM IN 2008
The Collapse of the U.S. Financial System in 2008
In 2008, the nation witnessed the highest level of bankruptcies and stock losses since the
1930s. The worldwide chaos that ensued affected governments and lenders throughout most of
the industrialized world. There was disruption in global markets, cash emergencies for
businesses at all levels, and the worst stock market performance since the Great Depression.
Several macroeconomic indicators, such as a drastic drop in the Baltic Dry Index, portended this
crash.
The Baltic Dry Index is a measure of the cost of shipping dry goods—for example, the
cost of shipping iron ore from Capetown, South Africa to Singapore. In 2008, the Index actually
provided a warning signal for the global meltdown that was about to take place. It is a totally
independent measure, not being subject to market manipulation of any type. Brokers in London
set the Index based on the daily fluctuations in the cost of moving coal, wheat and commodities
around the world. If it falls, it indicates a slackening of demand on a global scale. When the
Index fell by 66 percent in 2008, it provided an independent benchmark for investors around the
world.
Risk failures were shared by investors, homeowners and the institutions who were
promoting the new leverage. Institutions provided a dearth of information on the consequences
and details of the new financing instruments they were offering. Lenders had an unrealistic
business model. The derivatives that were created that were backed by subprime paper did not
adequately disclose investment risk. Credit agencies on the surface seemed to approve of the
new financing instruments, but didn’t dig deeply enough to understand them. Finally, regulators
did not monitor and provide correct oversight of the broad picture.
3

4. THE COLLAPSE OF THE U.S. FINANCIAL SYSTEM IN 2008
Why were institutions and individuals blindsided by the financial tsunami of 2008? The
answer is that they did not understand that liquidity can be an illusion. It is there when you don’t
need it but “gone with the wind” when you do. All evidence indicates that the economic systems,
supposedly self-sufficient and self-regulating, are not. The solution may lie in higher levels of
regulation.
The Holy Grail of macroeconomics is a proper understanding of the Great Depression. The
Great Depression was caused by a liquidity crisis combined with extremely inappropriate
monetary policies of the banks and market at the time. The debt structure was overloaded, with
$1.70 in debt for every dollar of the GDP. In 2008, the figure was twice that amount. As of
March 4, 2009, the total U.S. federal debt was $10,942,165,294,650. In 1929 derivatives did not
exist but today the main US banks hold close to $ 180 trillion in these vehicles.
Comparison of Films
Too Big to Fail was a documentary (Hanson, 2011) produced that primarily discussed the
events that led to the Lehman failure, and the remediation efforts of the government that
followed. When Lehman failed on September 15, 2008, it had $ 639 billion in assets and $619
billion in debt. It was the largest bankruptcy in history. At the time, it was the fourth largest
investment bank. Lehman’s collapse was the predecessor to $10 trillion lost in market
speculation.
Deregulation, begun under the office of President Reagan, continued throughout
subsequent administrations. Alan Greenspan, head of the Federal Reserve, did not condone
regulation, even of the volatile derivatives market. He found it best to have matters handled
“privately.” AIG was a primary result of this failed policy. It was hours away from making
trillions in derivative contracts worthless through its implosion when it was rescued by the
4

5. THE COLLAPSE OF THE U.S. FINANCIAL SYSTEM IN 2008
government. The only investment banking house to have foreseen the problem and insured itself
was Goldman. Though Goldman Sachs was itself promoting the CDOs that became worth
pennies on the dollar, they hedged their bets with purchases of Credit Default Swaps, insuring
their losses.
The Commodities Futures Modernization Act, passed in 2000, assured the derivative
market of its existence free of regulation. Thus, the major investment banks, including Goldman,
Morgan Stanley, Lehman Brothers, Merrill Lynch and Bear Stearns were free to pursue an open-
ended policy of creating major portfolios of CDOs comprised of low-quality assets. CDOs make
the older concept of securitization out of date. The people who make the loan are no longer at
risk for repayment. Mortgages, credit card and bank debt were all wrapped up in tranches of the
CDOs and sold to institutional and private investors. The higher the risk, the higher the interest
rate and the more pleased everyone was. The major rating agencies valued many CDOs as AAA,
the highest rating possible. Even CDOs with subprime loans were rated AAA.
Banks know when they’re very large they will be bailed. The top ten banks (77% of market
value) were chosen by Henry (Hank) Paulson, U.S. Treasury Secretary, to be recipients of
government bail-out funds designated as TARP (Troubled Asset Relief Program). This was
implemented under the Emergency Economic Stabilization Act of 2008 (EESA) as amended
by the American Recovery and Reinvestment Act of 2009. The film implied that critics did
not care for the total lack of control over the use of funds, but also clearly stated that if a lot
of restrictions had been put into place that the banks may have refused the loans, creating
tremendous levels of market instability.
Inside Job (Ferguson, 2011) took a longer viewpoint of the entire crisis, and went into more
detail about who profited and why. For example, Countrywide, a subprime lender, made $97
5

6. THE COLLAPSE OF THE U.S. FINANCIAL SYSTEM IN 2008
billion in loans and $11 billion in profit during the period 2001-2007. Interestingly, Alan
Greenspan could have used the powers provided under the Home Ownership and Equity
Protection Act to protect consumers, but he elected to leave the results to the free market with
disastrous consequences.
The decline in home prices meant negative or zero equity for many homeowners. In fact in
March 2008, 8.8 million borrowers (representing 10.8% of the U.S. homeowners) were
upside down in their mortgages. Homeowners simply walked away from their mortgages,
leaving the banks with property known as Real Estate Owned.
Investment banks were using leverage up to 33/1. The Gramm–Leach–Bliley Act (GLBA),
also known as the Financial Services Modernization Act of 1999 replaced the Glass-Steagall
Act and this allowed banks with consumer deposit to engage in risky lending activities.
AIG was selling Credit Default Swaps (a mechanism to reimburse CDO losses) to a variety
of speculators. AIG was not required to establish corporate reserves. Large cash bonuses were
paid to commissioned salesmen. $500 million of these swaps were purchased between 2001 and
2007. Savvy traders like John Paulson, a hedge fund manager, made profits of up to $12 billion
by betting against these swaps.
The government according to the film was in the dark. Ben Bernanke, the chairman of the
Federal Reserve, said there is no risk in housing. This contrasted with an International
Monetary Fund officer and also a Hedge Fund Manager, Bill Ackmann, who foresaw the
exact problems that were occurring in the years beforehand. In February of 2008, the
Finance Minister of France warned Hank Paulson of the U.S. Treasury, but Paulson
responded that everything was “under control.”
6

7. THE COLLAPSE OF THE U.S. FINANCIAL SYSTEM IN 2008
Only a month later, in March of 2008, Bear Stearns ran out of cash. They were acquired by
JP Morgan at $2/share. Strangely, they were rated very highly the same year, just prior to
bankruptcy. In September of 2008 Fannie Mae was taken over by the government. It was
also in September of 2008 that Lehman announced massive stock losses and their stock
collapsed. Lehman was almost purchased by Barclays, but British regulators put a stop to it
and Lehman went down in history as the largest bankruptcy on record.
During the fall of 2008 AIG owed holders of Credit Default Swaps $13 billion and they
didn’t have the money to repay. In October of 2008 a $700 billion bailout occurred, but
foreclosures and layoffs continued. In December of 2008 it was announced that General
Motors was facing bankruptcy. The documentary noted that for the first time in history that
children had less education and less income than their parents.
Both films utilized documented timelines and market statistics which were verified through
online charting. The facts were accurately portrayed in both films. Each film reached
somewhat different conclusions as noted, but each conclusion was valid in light of the facts
and circumstances that were presented.
The Crisis and the Profession of Industrial Engineering
Three fundamental tenets of the Code of Ethics of Industrial Engineering are:
 Being honest and impartial, and serving with fidelity the public, their employers and clients.
 Engineers shall issue public statements only in an objective and truthful manner.
 Engineers shall act in professional matters for each employer or client as faithful agents or
trustees, and shall avoid conflicts of interest.
The subprime crisis had a major ethical dimension that may, in fact, have caused it. It has
been stated that the prime cause of the crisis was greed, by definition an excessive desire for
7

8. THE COLLAPSE OF THE U.S. FINANCIAL SYSTEM IN 2008
something, usually money. When the desire is beyond rationality and beyond need, it is defined
as greed. Greed is different from economic rationality, which is simply common sense in
business. Greed is much different.
The next ethical principle is the ability to restrain the desire for performance, whether it
be success or wealth, to consider the needs of others and the ethical constrains necessary to keep
conduct on a professional level. In other words, many managers in these companies knew
exactly what was happening but for reasons of expediency they said and did nothing. Their
careers could not be jeopardized for mere principles.
This led to the third situation: misleading advertising and statements, information
which was critical was withheld from key people, and unnecessary churning operations took
place to generate more revenue, falsely creating the impression of wealth being created and stock
prices increasing.
In summary, engineers uphold and advance the integrity of their profession by acting with
fundamental concern for others and the common good. The fundamental canons of ethics would
not permit the type of performance that was evidenced by managers in the subprime crisis of
2008, nor would ethics permit the circumstances that gave rise to 2008.
Conclusions
There were three sets of circumstances that evolved from the economic collapse. One was
the bankruptcy of Lehman, which put the global financial system on immediate notice of
collapse. However, the government promptly acted and restored confidence by October of
2008 through their fiscal programs, which included:
• TARP implemented by the Treasury under the Emergency Economic Stabilization Act of
2008 (EESA);
8

9. THE COLLAPSE OF THE U.S. FINANCIAL SYSTEM IN 2008
• Various discount window adjustments made under the Federal Reserve’s authority under
section 13(3) of the Federal Reserve Act;
• the FDIC’s use of its Deposit Insurance Fund including resolving failed banks and thrifts,
temporarily increasing deposit insurance coverage to US $250,000 per person per
institution and its Temporary Liquidity Guarantee Program (TLGP); and
• Treasury’s rescue of Fannie Mae and Freddie Mac pursuant to the authority granted by
the Housing Economic Recovery Act of 2008 (HERA) (Guynn, 2010).
The fiscal stimulus programs worked but led to high levels of public deficits and
triggered a sovereign debt crisis in Greece and certain other countries. Other countries which had
invested in the toxic assets were the subject of a second crisis. Germany, Belgium, Iceland,
Britain and Spain suffered similar market reverberations as the United States. Domestic
currencies depreciated, household debt rose and markets were adversely affected.
Finally, the sovereign debt crisis forced other governments to take extreme measures.
Risk of default was spread into a variety of countries.
Credit Rating Agencies were a prime topic of discussion, as they had failed to foresee or
correct the problem. Some believe that without adequate governmental regulation or proper self-
regulation the problem is continuing today. In May 2012, the European Commission published
standards that address the information that the CRAs will have to submit to achieve compliance.
This “level playing field standard” has not been accompanied by similar legislation yet in the
U.S.
In the U.S., CRAs are governed by the Securities and Exchange Commission (SEC). In
2006 the Credit Rating Agency Reform Act was passed, and this gave the SEC authority of
registration, recordkeeping and oversight of CRAs. The Dodd-Frank Act of 2010 has adopted
9

10. THE COLLAPSE OF THE U.S. FINANCIAL SYSTEM IN 2008
new CRA rules, including requirements for each federal agency to review how its regulations
rely on credit ratings (Verschoor, 2013).
Business ethics emphasize a core concept— moral courage. The corporation and those
who work for it are individually responsible for excellence, integrity and the use of sound
business judgment. Honesty, trust and empathy are principles in the Code of Ethics, and should
be exemplified in behavior and not lip service in not only the profession of engineering, but since
they are all common to humanity, in all professions and most of all the profession of business.
10

11. THE COLLAPSE OF THE U.S. FINANCIAL SYSTEM IN 2008
References
Ferguson, C. (Director), Inside Job.[Motion picture on DVD]. (2011). Sony Pictures Home
Entertainment.
Guynn, R. (2010, November 20). The Financial Panic of 2008 and Financial Regulatory Reform.
Retrieved November 13, 2014, from
http://blogs.law.harvard.edu/corpgov/2010/11/20/the-financial-panic-of-2008-and-
financial-regulatory-reform/
Hanson, C. (Director), Too Big to Fail.[Motion picture on DVD]. (2011). HBO Films.
Institute of Industrial Engineers (2014). Engineering Code of Ethics. Retrieved November 13,
2014, from https://www.iienet2.org/details.aspx?id=299
Ngassam, C. (2013). The mortgage industry's role in the current global financial meltdown:
historical perspective and recommendations. Academy of Accounting and Financial
Studies Journal, 17(2), 1+. Retrieved from http://edb.pbclibrary.org:2077/ps/i.do?
id=GALE
%7CA332655962&v=2.1&u=d0_mlpbcls&it=r&p=AONE&sw=w&asid=f2e9495199dc
5740d42990363149f2cb
Verschoor, C. C. (2013, January). Credit rating agency performance needs improvement: the
continued poor performance of the credit rating agencies in providing adequate assurance
of the creditworthiness of debt instruments requires stronger action from regulatory
11

12. THE COLLAPSE OF THE U.S. FINANCIAL SYSTEM IN 2008
bodies. Strategic Finance, 94(7), 17+. Retrieved from
http://edb.pbclibrary.org:2077/ps/i.do?id=GALE
%7CA315371312&v=2.1&u=d0_mlpbcls&it=r&p=AONE&sw=w&asid=c71f06dc46f5f
046dea4d4a864497edd
12