It’s been a little over a year since Lehman Brothers went bankrupt and the world’s financial crisis teetered on the verge of collapse. The stock market was in a free fall, bank failures were happening all over the place and many even questioned the security of money placed into money market funds. The world was on the edge of a second great depression. Banks didn’t trust each other and people didn’t know where to place their funds.
What was the cause of the great depression? Excessive speculation at home and abroad was a major consideration. Many institutions thought that they were simply too big to fail and that they could do just about whatever they wanted to without consequence. AIG was involved in credit default swaps where they were insuring people that had bought financial instruments such as mortgage backed securities. AIG was supposed to step in after a default and make the investors whole, but the company had no reserves to do so. Eventually, AIG essentially became a ward of the state.
At the same time, U.S. regulatory authorities allowed banks to leverage themselves on a ratio of 30:1, taking on far too much risk for their own financial security.
The world ended up in a no-win scenario. If the banks weren’t bailed out, the world would have likely plunged into a depression. If the banks were bailed out, trillions worth of taxpayer funds would be spent. According to the Financial Times of London, its estimated that the bailout of the banks cost $8.955 trillion—almost the entirety of the GDP for the United States for just one year.
Out of that money, $2 trillion was given to financial institutions to remain solvent. Another $2.5 trillion was allocated for the feds to purchase toxic assets and another $4.5 trillion was given in guarantees. Fortunately, the government will likely not have to pay all of the guarantees that it has signed up for. It will only need to pay them if the assets that they guarantee go into default.
The nation’s economy has been harmed almost immeasurably. There’s been a massive wave of federal spending, unemployment and excessive public borrowing. Incomes are declining and personal investors have seen significant losses in their 401(k) and IRA plans. The mortgage market is now almost entirely a public entity, with the federal government purchasing nearly all real estate loans through Freddie Mac and Fannie Mae.
Many have suggested a new consumer financial protection agency to make sure a second financial crisis happen again. Others have suggested new accounting rules to prevent bank from taking on too much risk. Some have advocated ending some of the financial institutions that have been around for nearly a century. No one can be 100% what the best long-term solution will be, but the financial system will never be the same again.
