How The Real Estate Industry Played A Role In The 2008 Crash

January 5, 2022

If you were to pick one single word to describe the 2008 market crash, it would have to be “leverage.” As with most crashes, over-leveraging some or multiple segments of the market was ultimately the root cause. Another keyword one might reference in regards to this crash is the word, “speculation.”

What Is A Subprime Loan?

In the case of the 2008 crash, the specific market segment that was most over-leveraged and speculated upon was the subprime mortgage market. A subprime mortgage is a type of home loan given to applicants either on the edge of credit worthiness for a home loan or altogether not qualified at all. These are applicants who barely, if at all, qualify based on bank requirements pertaining to individual creditworthiness.

Logically, because the applicants taking out the loans themselves were considered credit risks, the banks should probably have considered the loans themselves to be risky as well. While the issuing banks of these subprime loans ultimately did charge a stiff premium over market rates, or “prime rates,” that measure alone wasn’t enough to prevent the systemic failure that loomed on the horizon.

Leverage And Speculation

So, we had these high-risk, high-reward credit instruments known as subprime loans. Put simply, bankers weren’t happy to leave well enough alone, earning the return these instruments provided on their own. They were eager to devise a new way to earn even greater returns on their risky paper.

So, they developed an entirely new asset type. What they developed were special financial instruments called collateralized debt obligations or CDOs.  One such instrument had to do with subprime mortgages and was called the “mortgage-backed security.” Pardon the pig-latin for any of us who don’t speak Wall Street, but these were all moving pieces on the board that aligned to cause the 2008 market crash, so they bear knowing.

Mortgage-backed securities were essentially hedge funds composed of nothing but baskets of these subprime mortgages. Now, much like other market crashes of the past, we have new financial instruments competing in a market where traders are not entirely familiar with them.

The House Comes Crashing Down

As the popular metaphor goes of the “house of playing cards” — so went the economy in 2008.  Built upon fragile and teetering ground, it was destined to come down, and any amount of further growth only made the inevitable crash more pronounced and destructive for those who had invested heavily in the market.

Before long, the new mortgage-backed security funds started going belly-up. As the underlying assets collected defaults in the form of the non-payment of mortgages, the funds built upon those loans also began to show rather devastating losses.

This is where the whole mess began to affect the regular investor, as some retirement funds were already allocating client’s assets into these risky new funds. There were even insurance policies being sold by the very same banks who were selling mortgage-backed securities in the first place. These policies were designed to pay out in case the mortgage-backed funds posted losses.

In retrospect, many financial minds have accused the banks involved at the time of knowing quite well what fate awaited them. There is certainly reason to suppose that the mortgage-backed securities were poor investments, as other institutions were literally hedging their bets by selling insurance policies against them at the same time.

The Government’s Response

The fallout from the 2008 crash enlisted the help of many different forms of band-aids and panaceas. These even included presidential bailouts, including Obama’s infamous “cash for clunkers” program, which is forever etched into history alongside memories of the great recession of 2008.

Banks were being bailed out left and right, while other banks were allowed to go under.  Lehman Brothers and Behr Sterns were two of the early casualties in the great recession, with many other financial institutions restructuring or altogether being bought out by other more solvent firms.

Loans were given to auto-makers General Motors and Dahlmer Chrysler, while Ford was lucky enough to remain sufficiently solvent.

Even regular working-age Americans received direct deposits of $600 from the federal government into their bank accounts, an unprecedented occurrence at the time.

Surely the tab for the 2008 bailouts seems somewhat modest in light of the recent government stimulus money spent in the midst of the COVID-19 crisis. At the time, the estimates ranged from somewhere around $500 billion up into figures above $1 trillion.

Regardless of where exactly the decimal place fell in the final calculations, the numbers were phenomenal, and many regular household investment accounts took the haircut along with major firms. It was a time of belt tightening and uncertainty for nearly all Americans and for all those internationally whose livelihood was linked to American prosperity, if not mere solvency.

Long-Term Upkeep And Repair

Certainly there were various measures taken in the aftermath of the crash that were aimed at patching vulnerabilities that led to the 2008 crash. The most well-known and arguably the most important of these legislative measures was the Dodd Frank Wall Street Reform and Consumer Protection Act. What this bill accomplished, among other finer details, was to provide greater oversight and restrict some of the ways banks and investment firms were allowed to invest their assets.

One such provision included under Dodd Frank was the The Volcker Rule which limited consumer banks such as those who offered conventional checking and savings accounts from putting deposit account funds into speculative investment assets, such as the mortgage-backed instruments so popular among institutions in the lead up to the 2008 event.

While some of the impact of the crash could have been minimized by more level-headed foresight and proper regulatory involvement earlier on, it does remain to be seen whether any lessons were really learned in the long term.

In the wake of the latest downturn caused by the COVID pandemic, we once again saw investors big and small scurrying to enter and exit positions, with both greed and fear holding the proverbial reins. Undoubtedly, investments carry a potential risk of loss and the greater prevailing economic climate is one factor that affects nearly all market segments.

Of course, governments would like to assure their citizens that all the bugs have been worked out of our financial markets and that all the regulations on the books today are sufficient to keep us all enjoying steady growth across market sectors. But wise investors will always keep their fingers on the pulse of the economy, watching to see if new developments or evolutions in market conditions have any chance of affecting their positions.

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