Sunday, June 26, 2011

2007-2009 Financial Meltdown

[Author: William V. Rapp, New Jersey Institute of Technology]

In the Fall of 2007 the Dow Jones Industrial index reached an all time high over 14,000. By November 2008 it had fallen under 8000. Other stock market indices worldwide including the high growth emerging economies of India and China saw similar or greater drops. Those predicting these economies had developed an Asian regional economy that would prove relatively robust despite problems in US and European financial markets were wrong. Mirroring this change in financial fortune in March 2008 Bear Sterns one of five major US investment banks and a leader in subprime mortgage lending collapsed leading to a rescue merger with JP Morgan Chase engineered by the Federal Reserve. This was followed in September by the failure of another major US investment bank and leader in subprime mortgage financing, Lehman Brothers. It was the largest bankruptcy in US history at over $600 billion. Then came the disappearance of Washington Mutual, the largest bank collapse in US history, and another JP Morgan Chase rescue, this time engineered by the Federal Deposit Insurance Corporation (FDIC). Further during 2008 and later in early 2009 the US government needed to rescue several large financial institutions with billions of dollars in loans and capital injections. These included AIG, Citicorp, and Bank of America. European governments too had to undertake similar actions.

Yet despite its global reach and historically severe adverse economic impact the meltdown reflects all the traditional characteristics of a classic boom and bust fed by excess credit. This is seen in the development of the housing bubble beginning in 2003 through its peak in August 2005 and finally the collapse in 2007 and 2008 of the mortgage and housing markets with their legal, economic and political aftermath. Indeed any reasonable analysis of the boom based on the classic boom and bust scenario should have raised early policy warnings about the housing bubble and its inherent risks. What was not fully appreciated even by those predicting a collapse was the scale and worldwide scope that magnified the financial and economic impact of the housing market’s collapse so as to trigger a global decline in credit availability even to large corporations and financial institutions resulting in a global recession.

However, to grasp how the subprime and US housing bubbles and their crash triggered the 2007-2009 Financial Meltdown and its current aftershocks, one must understand key changes that have occurred in the markets for US mortgage related securities and their legal underpinnings along with how computerization and the Internet provided global scale, while changes in US banking and security laws have complicated finding a solution.

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