As the Federal Reserve’s name makes a more frequent appearance on the radio and newspapers in response to President Trump’s constant calls to “lower interest rates,” it becomes fairly crucial to understand what system the Fed is monitoring and how past systems have adapted to their changing systems.
The 2008 Financial Crisis, or Global Financial Crisis, on a basic level, was a major worldwide financial crisis. Centered around the United States’ bursting housing bubble and subprime mortgage crisis, the financial crisis rivaled the Great Depression and ultimately called for new frameworks to ensure the functionality of monetary policy.
What Caused the 2008 Financial Crisis?
The 2008 financial crisis was fueled by excessive speculation in housing values, predatory lending for subprime mortgages, and deficiencies in regulation. By the early 2000s, the US housing market experienced a massive boom, driving up home prices. Fueled by historically low interest rates and loose lending standards, homeowners and financial institutions took excessive amounts of risk. Many borrowers, including those with poor credit histories, were able to obtain mortgages they normally could not afford. These mortgages were often bundled together and sold as mortgage-backed securities and collateralized debt obligations to investors around the world. When the housing bubble finally burst, causing housing prices to steeply decline, many subprime borrowers defaulted on their mortgages, leading to significant losses for financial institutions holding those securities. The collapse of these markets then triggered a liquidity crisis, as banks became reluctant to lend to each other and businesses and consumers. This, in turn, led to a “credit crunch” and a sharp decline in economic activity.
TED Spread - perceived Credit Risk Graph (source)
Key Events of the 2008 Financial Crisis
[1] Subprime Mortgage Crisis: The crisis began in early 2007 with the collapse of the subprime mortgage market. As mortgage defaults increased, the value of MBS and CDOs plummeted, causing significant losses for financial institutions.
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[2] Liquidity Crisis: By mid-2007, the liquidity crisis had spread to global institutions. Banks became increasingly reluctant to lend to each other, leading to a freeze in the global lending system.
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[3] Lehman Brothers Bankruptcy: On September 15, 2008, Lehman Brothers, the fourth-largest U.S. investment bank, filed for bankruptcy. This event is often considered the climax of the 2008 financial crisis, as it triggered a panic in financial markets worldwide. Investors began pulling their money out of banks and investment funds, leading to a further freeze in credit markets.
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[4] Government Response: In response to the crisis, governments and central banks around the world implemented unprecedented measures to stabilize the financial system. The U.S. government passed the Emergency Economic Stabilization Act of 2008, which included the $700 billion Troubled Asset Relief Program (TARP) to purchase toxic assets from banks.
Ample Reserves and the Federal Reserve's Response
As a response to the crisis in 2008, the Fed implemented a series of newly formed monetary policies, including quantitative easing, to inject liquidity into the financial system and stimulate economic growth. This system relied on the large-scale purchase of government bonds, which significantly increased the Fed’s balance sheet and the amount of bank reserves in the banking system. This shift to “ample reserves” marked a significant turning point in the implementation of monetary policy. Under the previous system, the Fed relied on a limited amount of reserves to influence the federal funds rate. However, with the increase in reserves due to QE, the Fed transitioned to a “floor-based system”. This system relied on interest on bank reserves to set a floor for the federal funds rate, allowing the Fed to maintain control over short-term interest rates even with a large balance sheet.
Sources
https://www.federalreservehistory.org/essays/great-recession-and-its-aftermath
https://www.cfr.org/timeline/us-financial-crisis
https://www.americanprogress.org/article/2008-housing-crisis/
https://www.investopedia.com/terms/m/mbs.asp
https://www.chicagobooth.edu/review/how-quantitative-easing-actually-works
https://www.investopedia.com/news/10-years-later-lessons-financial-crisis/ (image)