The Fall of the Market in the Fall of 2008

Mortgage crisis. Credit crisis. Bank collapse. Government bailout. Phrases like these frequently appeared in the headlines throughout the fall of 2008, a period in which the major financial markets lost more than 30% of their value. This period also ranks among the most horrific in U.S. financial market history. Those who lived through these events will likely never forget the turmoil. So what happened, exactly, and why? Read on to learn how the explosive growth of the subprime mortgage market, which began in 1999, played a significant role in setting the stage for the turmoil that would unfold just nine years later.

Subprime mortgages are mortgages targeted at borrowers with less-than-perfect credit and less-than-adequate savings. An increase in subprime borrowing began in 1999 as the Federal National Mortgage Association (widely referred to as Fannie Mae) began a concerted effort to make home loans more accessible to those with lower credit and savings than lenders typically required. The idea was to help everyone attain the American dream of home ownership. Since these borrowers were considered high-risk, their mortgages had unconventional terms that reflected that risk, such as higher interest rates and variable payments. (Learn more in Subprime Lending: Helping Hand Or Underhanded?)

While many saw great prosperity as the subprime market began to explode, others began to see red flags and potential danger for the economy. Bob Prechter, the founder of Elliott Wave International, consistently argued that the out-of-control mortgage market was a threat to the U.S. economy as the whole industry was dependent on ever-increasing property values.

As of 2002, government-sponsored mortgage lenders Fannie Mae and Freddie Mac had extended more than $3 trillion worth of mortgage credit. In his 2002 book "Conquer the Crash," Prechter stated, "confidence is the only thing holding up this giant house of cards." The role of Fannie and Freddie is to repurchase mortgages from the lenders who originated them,and make money when mortgage notes are paid. Thus, ever-increasing mortgage default rates led to a crippling decrease in revenue for these two companies. (Learn more in Fannie Mae, Freddie Mac And The Credit Crisis Of 2008.)

Among the most potentially lethal of the mortgages offered to subprime borrowers were the interest-only ARM and the payment option ARM, both adjustable-rate mortgages (ARMs). Both of these mortgage types have the borrower making much lower initial payments than would be due under a fixed-rate mortgage. After a period of time, often only two or three years, these ARMs reset. The payments then fluctuate as frequently as monthly, often becoming much larger than the initial payments. (For more on this type of mortgage, see This ARM Has Teeth.)

In the up-trending market that existed from 1999 through 2005, these mortgages were virtually risk-free. A borrower, having positive equity despite the low mortgage payments since his home had increased in value since the purchase date, could just sell the home for a profit in the event he could not afford the future higher payments. However, many argued that these creative mortgages were a disaster waiting to happen in the event of a housing market downturn, which would put owners in a negative equity situation and make it impossible to sell.

To compound the potential mortgage risk, total consumer debt, in general, continued to grow at an astonishing rate and in 2004, it hit $2 trillion for the first time. Howard S. Dvorkin, president and founder of Consolidated Credit Counseling Services Inc., a nonprofit debt management organization, told the Washington Post at the time, "It's a huge problem. You cannot be the wealthiest country in the world and have all your countrymen be up to their neck in debt."

During the run-up in housing prices, the mortgage-backed securities (MBS) market became popular with commercial investors. An MBS is a pool of mortgages grouped into a single security. Investors benefit from the premiums and interest payments on the individual mortgages it contains. This market is highly profitable as long as home prices continue to rise and homeowners continue to make their mortgage payments. The risks, however, became all too real as housing prices began to plummet and homeowners began to default on their mortgages in droves. (Learn how four major players slice and dice your mortgage in the secondary market in Behind The Scenes Of Your Mortgage.)

Another popular investment vehicle during this time was the credit derivative, known as a credit default swap (CDSs). CDSs were designed to be a method of hedging against a company's creditworthiness, similar to insurance. But unlike the insurance market, the CDS market was unregulated, meaning there was no requirement that the issuers of CDS contracts maintain enough money in reserve to pay out under a worst-case scenario (such as an economic downturn). This was exactly what happened with American International Group (AIG) in early 2008 as it announced huge losses in its portfolio of underwritten CDS contracts that it could not afford to pay up on. (Learn more about this investment vehicle in Credit Default Swaps: An Introduction and Falling Giant: A Case Study Of AIG.)

By March 2007, with the failure of Bear Stearns due to huge losses resulting from its involvement in having underwritten many of the investment vehicles directly linked to the subprime mortgage market, it became evident that the entire subprime lending market was in trouble. Homeowners were defaulting at high rates as all of the creative variations of subprime mortgages were resetting to higher payments while home prices declined. Homeowners were upside down - they owed more on their mortgages than their homes were worth - and could no longer just flip their way out of their homes if they couldn't make the new, higher payments. Instead, they lost their homes to foreclosure and often filed for bankruptcy in the process. (Take a look at the factors that caused this market to flare up and burn out in The Fuel That Fed The Subprime Meltdown.)

Despite this apparent mess, the financial markets continued higher into October of 2007, with the Dow Jones Industrial Average (DJIA) reaching a closing high of 14,164 on October 9, 2007. The turmoil eventually caught up, and by December 2007 the United States had fallen into a recession. By early July 2008, the Dow Jones Industrial Average would trade below 11,000 for the first time in over two years. That would not be the end of the decline.

On Sunday, September 7, 2008, with the financial markets down nearly 20% from the October 2007 peaks, the government announced its takeover of Fannie Mae and Freddie Mac as a result of losses from heavy exposure to the collapsing subprime mortgage market. One week later, on September 14, major investment firm Lehman Brothers succumbed to its own overexposure to the subprime mortgage market and announced the largest bankruptcy filing in U.S. history at that time. The next day, markets plummeted and the Dow closed down 499 points at 10,917.

The collapse of Lehman cascaded, resulting in the net asset value of the Reserve Primary Fund falling below $1 per share on September 16, 2008. Investors then were informed that for every $1 invested, they were entitled to only 97 cents. This loss was due to the holding of commercial paper issued by Lehman and was only the second time in history that a money market fund's share value has "broken the buck." Panic ensued in the money market fund industry, resulting in massive redemption requests. (For related reading, see Will Your Money Market Fund Break The Buck? and Case Study: The Collapse of Lehman Brothers.)

On the same day, Bank of America (NYSE: BAC) announced that it was buying Merrill Lynch, the nation's largest brokerage company. Additionally AIG (NYSE: AIG), one of the nation's leading financial companies, had its credit downgraded as a result of having underwritten more credit derivative contracts than it could afford to pay off. On September 18, 2008, talk of a government bailout began, sending the Dow up 410 points. The next day, Treasury Secretary Henry Paulson proposed that a Troubled Asset Relief Program (TARP) of as much as $1 trillion be made available to buy up toxic debt to ward off a complete financial meltdown. Also on this day, the Securities and Exchange Commission (SEC) initiated a temporary ban on short-selling the stocks of financial companies, believing this would stabilize the markets. The markets surged on the news and investors sent the Dow up 456 points to an intraday high of 11,483, finally closing up 361 at 11,388. These highs would prove to be of historical importance as the financial markets were about to undergo three weeks of complete turmoil.

The Dow would plummet 3,600 points from the September 19, 2008, intraday high of 11,483 to the October 10, 2008, intraday low of 7,882. The following is a recap of the major U.S. events that unfolded during this historic three-week period.

• September 21, 2008: Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), the last two of the major investment banks still standing, convert from investment banks to bank holding companies to gain more flexibility for obtaining bailout funding.
• September 25, 2008: After a 10-day bank run, the Federal Deposit Insurance Corporation (FDIC) seizes Washington Mutual, then the nation's largest savings and loan, which had been heavily exposed to subprime mortgage debt. Its assets are transferred to JPMorgan Chase (NYSE:JPM).
• September 28, 2008: The TARP bailout plan stalls in Congress.
• September 29, 2008: The Dow declines 774 points (6.98%), the largest point drop in history. Also, Citigroup (NYSE:C) acquires Wachovia, then the fourth-largest U.S. bank.
• October 3, 2008: A reworked $700 billion TARP plan, renamed the Emergency Economic Stabilization Act of 2008, passes a bipartisan vote in Congress. (U.S. bailouts date all the way back to 1792. Learn how the biggest ones affected the economy in Top 6 U.S. Government Financial Bailouts.)

The events of the fall of 2008 are a lesson in what eventually happens when rational thinking gives way to irrationality. While good intentions were likely the catalyst leading to the decision to expand the subprime mortgage market back in 1999, somewhere along the way the United States lost its senses. The higher home prices went, the more creative lenders got in an effort to keeping them going even higher, with a seemingly complete disregard for the potential consequences. When one considers the irrational growth of the subprime mortgage market along with the investment vehicles creatively derived from it, combined with the explosion of consumer debt, maybe the financial turmoil of 2008 was not as unforeseeable as many would like to believe.

Find out how this tough economic period can be a learning experience for all in The Bright Side Of The Credit Crisis.