Preventing the Engine of Doom: A Lesson on Financial Crisis

Nicolas Espinosa

Associate Editor

Loyola University Chicago School of Law, JD 2024

The Great Financial Crisis of 2008 was a story of greed. In markets where incentives lead to bad behavior, disparately affecting a great deal of society, we rely on regulatory oversight. A domino effect of decisions spanning decades resulted in a global economic disaster, but it could have been prevented with effective regulators.

The combination of large investment banks going public in the 1980s, Fannie Mae and Freddie Mac’s status as both private corporations and de facto government agencies – an unreliable concept from the start, and most importantly a complete failure of oversight, monitoring, and enforcement by the ratings agencies all came together to bring about the Financial Crisis of 2008.

There is a nearly 50% chance of recession by July of 2023 according to economists in a recent Reuters poll. The probability for recession has surged this year. It is reasonable to reflect on the missteps of one of the worst financial disasters in American history. While strong safeguards have since been implemented to diminish the likelihood of a repeat financial crisis, it is important to review the safeguards that ultimately failed the American public in 2008.

The failures of the ratings agencies

The public profiteering of Wall Street did not stop at the banks. Eventually Moody’s and Standard & Poor’s (S&P) went public, and the cash came pouring in. Moody’s went public in 2000 and their revenues went from $800 million in 2001 to $2.03 billion in 2006. More than half of the increase came from the home finance sector. The ratings agencies never should have gone public, and neither should have Freddie Mac and Fannie Mae.

The failures of Moody’s and S&P are seemingly endless leading up to the financial crisis. The rating agencies were a free-market tool that should have effectively put an end to the excessive money dance of the structured finance world, but they failed. For a public company, making money for the shareholders is vital and this lesson is among the first principles taught in business school. The ratings agencies made their money by essentially selling ratings. If they gave a poorer rating than a competing rating agency, they would lose business and therefore profit.

Excessive risk made its way to the historically effective MBS. Eventually the Credit Default Swap (CDS) and Collateralized Debt Obligation (CDO) were embraced by Wall Street. Both instruments were invented to redistribute the risk of corporate and government bond defaults. Eventually the instruments hid risk successfully through false assumptions made by ratings agencies.

For example, the CDO, a derivative security often full of triple-B rated mortgages would be rated triple-A under the false assumption the mortgages were uncorrelated. Further, a floating rate mortgage was preferred over a fixed rate because by the time the teaser rate ended, the risk had been transferred from the original lender and into the fixed income market, or the borrower would refinance for additional fees if their property increased in value. The portion of subprime mortgages with a floating rate had risen from 40 percent to 80 percent in the five years preceding the financial crisis.

When the ratings agencies finally began to recognize their miscalculation, they gave financial institutions another handout. In May 2006, S&P announced plans to change their model used to rate sub-prime mortgage bonds. Notably, the change would not go into effect for months. So, the creation of subprime bonds shot up dramatically as financial institutions stuffed the channel. Today, we know that $400 billion of CDOs were created in the three years preceding the crash, and none of them were properly rated.

The Wall Street bailout

The eventual crash led to a government bailout which largely was paid for by everyday citizens of the United States. TARP was enacted for $700 billion. The US Federal Reserve (the Fed) bought subprime mortgages directly from the banks. Those risks and losses were transferrable to the taxpayer at a cost of greater than $1 trillion.

On Wall Street in 2008 everyday folks were left to dry while a select few exited safely from their C-Suite with more cash in hand than when they arrived.

Looming recession

Jerome Powell, Chairman of the Federal Reserve, announced the latest interest rate hike on September 21, 2022, marking the highest benchmark rate since early 2008.

As the Fed has continued to hike interest rates, the housing boom seen during the pandemic has officially begun its cool down. As of September, mortgage applications to purchase a home have fallen 23% from a year ago.

While there is a low supply in housing, a decrease in demand will lead to a decrease in price. When this occurs a spike in negative home equity rates will likely be followed by a rise in default rates. This was long avoided leading up to the Great Financial Crisis due to homeowners refinancing their mortgage. Today, refinancing is generally off the table due to the increase in interest rates.

Black Knight Data & Analytics reported in July that roughly 275k U.S. borrowers would fall underwater from a 5% national home price decline.

Michael Burry, the hedge fund manager made famous by “The Big Short,” has warned retail investors that a crash is coming. “We have not hit bottom yet,” he tweeted on September 7. Burry has also raised concerns for housing, meme stocks, and cryptocurrencies.

Following the Great Financial Crisis of 2008, the United States implemented a new era of financial regulation. This includes the Financial Stability Oversight Committee (FSOC) in an attempt to prevent the economy from “too big to fail” institutions. Dodd-Frank further mandated the Federal Reserve to closely examine the largest financial institutions through stress testing, monitoring derivative trading, strengthening the Sarbanes-Oxley Act, and increasing reporting requirements for large hedge funds.

The effectiveness of modern financial regulation will be tested over the next two years. The immense failures of 2008 resulted in massive penalties for everyday Americans. It is timely to review the financial catastrophe and ensure it is never repeated.