In this episode, we ask how the actions of various American financial institutions caused a global recession and destroyed the livelihoods and homeownership of millions of American people. Then we figure out what the federal government decided to do about it. This is the 2008 financial crisis as told by Amy Friend, Chief Counsel to the Senate Banking Committee as the Dodd-Frank Wall Street Reform and Consumer Protection Act was written.
Transcript
The 2008 Financial Crisis Explained
Hannah McCarthy: [00:00:00] Uh, so, Nick, you know why I've brought you here today?
Nick Capodice: [00:00:04] I do.
Hannah McCarthy: [00:00:05] And my understanding is you're not terribly thrilled.
Nick Capodice: [00:00:08] No, because this is the sort of stuff that my brain, it just turns off, and it has for decades, and I'm excited to change that.
Hannah McCarthy: [00:00:19] All right, Nick. Well, I have got an industrious young entrepreneur story for you. Okay.
Nick Capodice: [00:00:25] I wasn't expecting that to start us off, but I like those as a rule.
Hannah McCarthy: [00:00:29] That's great. So it's 1844. A young man named Higham is living near Rome, PA, Germany, with his mom, his dad and his two brothers. Dad's a cattle dealer, but Higham decides he's going to strike out on his own. He's 23. He emigrates to the US, he changes his name to Henry and gets to peddling household goods around Alabama.
Nick Capodice: [00:00:53] Household goods? It's not like the most profitable business, but it's sort of a tried and true start.
Hannah McCarthy: [00:00:58] Yeah, it's a start. And [00:01:00] he manages to save enough money to open up a general store in Montgomery.
Nick Capodice: [00:01:04] Well, this is a nice story.
Hannah McCarthy: [00:01:05] It is a nice story.
Nick Capodice: [00:01:06] Is this Montgomery Ward?
Hannah McCarthy: [00:01:08] Montgomery, Alabama. Oh, So then one of Henry's brothers comes over from Germany, right? And then the other. And they all work together, and the store sells what they call Southern domestics. So sheets, shirts, yarn, a lot of stuff made from cotton.
Nick Capodice: [00:01:23] Okay, So cotton in the 1850s. That's right. And also in the south. So this is an industry pretty much entirely dependent on enslaved labor.
Hannah McCarthy: [00:01:33] Right. And that is going to come into play here in very short order. So these brothers, they add another cotton aspect to their business. They make the decision to accept cotton as payment for goods in their store.
Nick Capodice: [00:01:46] Raw cotton.
Hannah McCarthy: [00:01:47] That's right.
Nick Capodice: [00:01:47] Cotton. That I assume they can quickly turn around and sell.
Hannah McCarthy: [00:01:51] It is a hot commodity. And remember that word, Nick? Commodity. So Henry takes a trip to New Orleans in 1855, and he catches [00:02:00] yellow fever. Oh, dear. Yeah. Oh, dear. Is right. He dies, but his brothers carry on and eventually they go full cotton. Full cotton. They become cotton commodity brokers.
Nick Capodice: [00:02:11] So this is what's happened. That combination of words. As soon as you put them together, it made my brain turn off.
Hannah McCarthy: [00:02:16] Well, turn it back on, friend. It just means they buy raw cotton and they sell it to people who do something with it.
Nick Capodice: [00:02:22] Okay, I can get that. So. Like, they're the middlemen.
Hannah McCarthy: [00:02:25] Yeah. And the middlemen opened an office in New York City, the very seat of the commodities trading business in the US. And at this point, we are in the 1860s.
Nick Capodice: [00:02:34] Okay, good. I'm glad you got to this. That civil war is going to come around pretty soon and change things. But also, didn't Abraham Lincoln pretty explicitly banned Southern cotton from being sold to the north?
Hannah McCarthy: [00:02:46] Yes. And therein lay a potential hiccup for a business. Right. But not for these brothers, at least one of whom, by the way, was himself an enslaver. They simply acquired their cotton in the southern US, shipped it to England and then shipped [00:03:00] it back to New York. Problem solved.
Nick Capodice: [00:03:02] Well, that is a big old loophole that they're just exploiting there.
Hannah McCarthy: [00:03:06] A loophole that worked wonders for their business. They made it through the war. They helped start the Cotton Exchange in New York, and then they started to get into other commodities coffee, sugar, petroleum.
Nick Capodice: [00:03:19] You know, I definitely own this board game.
Hannah McCarthy: [00:03:21] Later comes real estate, railways, mining, textiles, even Nick, even municipal financing.
Nick Capodice: [00:03:30] You did it again there with those words.
Hannah McCarthy: [00:03:31] It's okay. Basically, all that it means is they helped Alabama do money stuff, right via bond.
Nick Capodice: [00:03:37] Keep keep that word out of your mouth. Keep that word away from me.
Hannah McCarthy: [00:03:40] All right, All right. You're nearly there. I'm going to speed up here. The next generation starts working in the family business and they become an investment bank.
Nick Capodice: [00:03:47] You know, this started out fun with farmers in Germany Securities.
Hannah McCarthy: [00:03:51] We're talking stocks. They get in on the ground floor of aviation and the movie business. At some point they get out of cotton and at some point they [00:04:00] get into oil.
Nick Capodice: [00:04:01] I mean, it sounds like these brothers were pretty good at seeing what is going to be worth lots of money in the future.
Hannah McCarthy: [00:04:07] So good, in fact, that people started to turn to them for advice and not just investment advice, but advice on mergers and acquiring companies and setting up foundations on pension funds. By the late 1970s, I told you we were speeding up. They are the fourth largest investment bank in the country. This company survived the Great Depression. It survived the 1970s oil crisis and later on it survived September 11th despite its threats to the global financial market.
Nick Capodice: [00:04:40] Wait, who exactly are these brothers?
Archival: [00:04:45] Lehman Brothers is going bankrupt and financial markets from Asia to Europe are doing their utmost to prevent Monday from turning from dark to black. Employees of America's fourth largest investment bank saw the writing on the wall late Sunday after. Talks [00:05:00] to pull them back from the abyss collapsed.
Hannah McCarthy: [00:05:02] By 2008, Nick Lehman Brothers was a 158 year old behemoth. It started out as a small household goods business in Alabama and ended up with $639 billion in assets, 25,000 employees worldwide, and a portfolio that would knock your socks off. And then it collapsed.
Archival: [00:05:27] Shares in Lehman Brothers have plummeted more than 80% in 2008 alone. Meanwhile, as markets everywhere react, the bottom to America's financial woes appear nowhere in sight. Monday will be a difficult day to face for Lehman's thousands of shareholders and more than 25,000 employees. Many had hoped this day would never come.
Nick Capodice: [00:05:59] I [00:06:00] knew this rapid rise entrepreneur story was a little bit too good to be true. This is about finance, isn't it, Hannah?
Hannah McCarthy: [00:06:06] But don't you want to know what happened?
Nick Capodice: [00:06:07] I was tricked into this. Hannah. I thought it was an immigrant tale.
Hannah McCarthy: [00:06:11] It was an immigrant tale. It just became something else. It became a part of one of the grandest catastrophes in American financial history, which means one of the grandest in the world. So don't you want to know what happened?
Nick Capodice: [00:06:28] Okay.
Hannah McCarthy: [00:06:28] Okay. This is Civics 101. I'm Hannah McCarthy.
Nick Capodice: [00:06:31] I'm Nick Capodice.
Hannah McCarthy: [00:06:32] And this is the 2008 financial crisis and what we did about it. So, Nick, Lehman Brothers isn't just an interesting entrepreneur story, obviously. It's also an interesting story because they did, in fact, collapse. They were allowed to go under. But the story of the 2008 financial crisis is largely one about preventing collapse at an enormous cost, specifically an [00:07:00] enormous cost to the federal government.
Nick Capodice: [00:07:03] Now you're talking about how the federal government bailed out a bunch of corporations.
Hannah McCarthy: [00:07:06] Save the companies, save the world. That was the legitimate calculation being made here.
Nick Capodice: [00:07:11] And this is where we get the phrase too big to fail, right?
Hannah McCarthy: [00:07:14] That's where we get it. And we're going to get to all of that. But before we go any further, I am bringing in someone who actually knows what she's talking about, someone who was.
Amy Friend: [00:07:23] There. Let's see. I had worked in the House for both individual members, including then-Congressman Schumer, who is now the majority leader in the Senate. And then I had also worked on what was then House Banking Committee, which is now House Financial Services Committee. And so I developed an expertise in the areas of banking and financial services.
Hannah McCarthy: [00:07:50] This is Amy Friend. Amy is going to help us understand. Amy has experience in both government work and banking work and then later in the Treasury Department. [00:08:00]
Nick Capodice: [00:08:00] So she understands banking really well.
Amy Friend: [00:08:03] So 2008 rolls around and then a former.
Amy Friend: [00:08:07] Colleague of mine had asked me to interview for a position as chief counsel.
Hannah McCarthy: [00:08:11] Chief counsel. What that means is that Amy is the lawyer who knows a lot of stuff, and she's helping out the Banking Committee.
Amy Friend: [00:08:20] But what I didn't know was that one month later, Bear Stearns, which was a big investment bank, would collapse. And that was sort of an early sign of things to come in the collapse of the housing market.
Nick Capodice: [00:08:42] So I was joking about it in the beginning. Hannah But I am going to be up front and honest and tell you I do not understand how or why an investment bank would collapse, and I do not know why it even matters that they do. And I also do not know what it means for a market of any kind, be it a housing market [00:09:00] or a fish market to collapse.
Hannah McCarthy: [00:09:02] Okay, let's lay the backdrop.
Amy Friend: [00:09:04] What happened in the early 2000s was there was a proliferation of subprime loans, which were loans that were made to people who have lower credit scores.
Nick Capodice: [00:09:15] All right. Break this down for me.
Hannah McCarthy: [00:09:18] Borrowing money, you get that part, right?
Nick Capodice: [00:09:19] Yes. Do I ever.
Hannah McCarthy: [00:09:21] You can borrow money from a bank in the form of, for example, a credit card or a student loan. But in this episode, we are talking mostly about loans that let you buy a house.
Nick Capodice: [00:09:32] Like a mortgage.
Hannah McCarthy: [00:09:33] Exactly. Which is typically a lot easier to get when you have a higher credit score.
Nick Capodice: [00:09:39] And a credit score being basically your grade for how well you pay off loans.
Hannah McCarthy: [00:09:44] Very good. Exactly. So if you're really reliable when it comes to paying your credit card bill, you might have a high credit score. If you're not reliable, you might have a low credit score. And by the way, the credit score system is considered discriminatory by many [00:10:00] and deeply based in a history of structural racism. That is a subject for another day. But it has got to be said here. So when it comes to houses, it is usually harder to get a mortgage when you have a low credit score or heaven forbid, no credit score, which happens if, for example, you have never borrowed money or taken out a credit card.
Amy Friend: [00:10:21] So there are subprime borrowers that have these lower scores or may not have any credit file at all because they may be renters and they may not be they may not own a home or they may not have credit cards. And so we call those sort of thin files or no files subprime.
Hannah McCarthy: [00:10:40] That word just think risky. A subprime borrower is someone who a financial institution believes is not responsible with loans. A subprime mortgage is what you call a mortgage that is given to a risky A.K. Low or no credit score borrower. A prime borrower, [00:11:00] by contrast, is someone the financial world has decided is good at borrowing money and paying it back. There are a lot of things that can make you a sub prime borrower. Sometimes it is not paying loans on time, sometimes it's borrowing a lot of money. That would take you a long time to pay back. Sometimes it is circumstances that have nothing to do with how quote unquote responsible you are, but instead have to do with the kind of financial resources you have access to or high medical bills or periods of unemployment, things like that.
Amy Friend: [00:11:30] What was happening in this subprime crisis in the early 2000s was that there was a lot of money in the system.
Nick Capodice: [00:11:36] What does she mean by a lot of money in the system?
Hannah McCarthy: [00:11:39] Okay. What we're talking about here is that there was a recession in 2001. So what happens is the Federal Reserve lowers interest rates way, way down to stimulate the economy. Interest rates are the fee that you pay to a lender who gave you a loan. When interest rates are low, people typically have more money because their loan bills [00:12:00] are not as high. They don't have these high fees on top. And lenders wanted.
Amy Friend: [00:12:05] To expand the envelope of who could.
[00:12:08] Get credit, but they didn't do it in a responsible way. They made loans that had.
Amy Friend: [00:12:15] Terms that many borrowers could not meet. So, for instance, they might have done something called an adjustable rate mortgage. Nothing wrong with that. And when an adjustable rate mortgage is, the borrower gets a mortgage at a certain rate for a period of time, and then it adjusts based on the interest rate. So it will go up, you know, chances are over a couple of years, then it could go up again and up again. So the lender might have said, well, you can.
[00:12:45] Repay at the first rate of interest. It might be.
Amy Friend: [00:12:49] Difficult for you to repay when this interest rate goes up. But don't worry, because traditionally, historically, all the models show [00:13:00] housing prices always go up.
[00:13:01] So you can refinance and you'll get you know, you'll have more equity because you will put money down.
Amy Friend: [00:13:08] You build up equity in the house as you pay off the loan, so you'll have more equity or you can sell your house and housing prices go up.
Nick Capodice: [00:13:15] You'll be able to pay your loan. Okay. All right. Let me try.
Hannah McCarthy: [00:13:18] This. Go for it.
Nick Capodice: [00:13:19] A person could get a loan even if they weren't really the best candidate, even if they were a risky candidate. And the lenders are telling these candidates that their monthly bill would be pretty doable, too. Right, Because interest rates were low. And by the time those interest rates went up and that monthly bill went up, their house would be worth more. Money, then it cost them to buy. So they could either just sell that house to pay off their mortgage or they could borrow even more money and use that money to pay their monthly mortgage bill.
Hannah McCarthy: [00:13:48] And that second thing you described has a couple of options - refinancing your mortgage, taking out a new one that takes your home's higher value into account, OR a home equity loan. So [00:14:00] back to the subprime, A.K.A. Risky Loan, right? A lot of the people who got one did not actually have enough money to even make a down payment on their house. By the way, this falls into the predatory lending category. It is at the heart of what would turn into a very bad situation.
Nick Capodice: [00:14:22] And when you say down payment, you mean a big chunk of change that you pay. That kind of proves, hey, I will definitely be able to afford this whole house eventually.
Hannah McCarthy: [00:14:32] But in the early 2000s, lenders essentially eliminated the typical requirements for some borrowers. They would also say maybe.
Amy Friend: [00:14:41] You don't need a down payment. You don't need a down payment. Just sign on the dotted line. What's your income? Well, you need X amount of income to qualify for this mortgage. Just put it down and we're not going to verify it. So they didn't verify income. These were called liar's loans [00:15:00] or they were interest only. You never get to pay the principal of the loan, so you don't actually pay it down.
Hannah McCarthy: [00:15:06] You're just paying the interest. By the way, these are called liar's loans because the lender is ostensibly just taking the borrower at their word, as in you say you can do it, great. We won't ask you for any documentation. But really, what's going on here, Nick, is that these financial institutions are telling the borrower that this is okay. That's the predatory part.
Nick Capodice: [00:15:28] This sounds like a really bad idea. Hannah It sounds like those storefronts that have giant signs saying get a loan today, no proof of income needed, no money down. Why on earth would any mortgage lender agree to do that?
Amy Friend: [00:15:42] So you would say, why would a lender that's going to keep these loans on their books make loans with such faulty terms and essentially not underwrite? So when you underwrite, you look at the debt that the consumer [00:16:00] has compared to the level of income and whether they can take on this new loan based on all of that. And that was not being done. And the reason that lenders could do this is because they sold those loans to Wall Street companies, to these investment banks.
Nick Capodice: [00:16:18] Wait, you can buy a loan. How can you buy a loan? How can you buy something that is like the opposite of something? How can you buy something that is like negative money?
Hannah McCarthy: [00:16:27] I'm going to try it like this. Okay. And just tell me if this makes sense, okay? Bob Bank gives Suzy Homebuyer a loan to pay for her house.
Nick Capodice: [00:16:36] All right, I'm with you.
Hannah McCarthy: [00:16:39] And Bob tells Susie she has 30 years to pay them back. And because the loan comes with a fee, aka an interest rate, Bob Bank will make a profit. But Bob Bank does the math and decides they don't want to wait 30 years to make a profit. That's forever. Also, what if Susie Homebuyer gets to a point where she can't pay [00:17:00] Bob anymore? How is Bob going to get all that money back with interest right away? And also not worry about Susie Homebuyer maybe not paying her mortgage?
Nick Capodice: [00:17:11] I didn't even know this was an option for Bob Bank. Is this the selling the loan part?
Hannah McCarthy: [00:17:16] It is Bob Bank talks to Janet Wall Street and Janet is like, yeah, okay, I'm interested. I'll buy that loan from you because I have a plan for this loan. I am also going to sell it. And by the way, can I get 99 more of these?
Nick Capodice: [00:17:34] So Susie Homebuyer's loan gets sold.
Hannah McCarthy: [00:17:37] Twice, essentially, and the second time it is sold, or we should say part of it is sold. It's in a big bundle with a bunch of other loans it's invested in. So Bob Bank gets money from Janet Wall Street and Janet Wall Street gets money from Alistair Investor.
Nick Capodice: [00:17:53] Alistair. Alistair, how fancy. So does that mean that ultimately it's some investor [00:18:00] in this case Alistair who is getting Susie Homebuyers payments.
Hannah McCarthy: [00:18:06] And profiting on the fees a.k.a. the interest and often Nick Alistair Investor That's actually a company or a municipality like a town or city or pension fund and Alistair Investor is not going to make a risky investment. Alistair wants to make a profit and is not going to make a real gamble.
Amy Friend: [00:18:29] They can only purchase the safe securities, right? So there are credit rating agencies that actually rate these bonds and they could be triple-A for the best. They could be B for not so good, be negative. You know, they sort of there's a range, right? And so these rating agencies that were paid by the issuers of these securities would rate these bonds. They give them triple-A ratings. Well, the market you [00:19:00] know, housing prices always go up if we're going to keep paying. This is great.
Nick Capodice: [00:19:04] Oh, okay. Okay. I'm getting this. So a triple A bond is a bond full of mortgages, like a bag of mortgages that are very likely to be paid back versus triple B's, which are probably a little more risky. Like all the borrowers in the Triple A bond have great credit scores and they're almost guaranteed to pay their mortgage. So companies and municipalities and pension funds want to buy those because they're not even a gamble. They're like a sure bet.
Hannah McCarthy: [00:19:31] They're so safe. Right. Such a safe investment. And this is where something, just to my mind, ridiculous happens. We're in the early 2000s, Right? Remember that these bonds, as we've said, this bag of mortgages, it's a bunch of mortgages and they're all bundled up together.
Nick Capodice: [00:19:56] And investors buy that bundle of mortgages and they [00:20:00] want the packages. They get to have good credit scores to be Triple A's.
Hannah McCarthy: [00:20:04] Yes. But at this point, again, in the early 2000s, the investment banks are doing something else. They are also buying a bunch of, quote unquote, risky mortgages, risky like we talked about, both for the lender and the borrower, because the mortgage lenders have been handing them out like hotcakes. So the investment banks are like, okay, how are we going to make a bunch of money on these not so stellar mortgages that we've acquired? I know. Let's just.
Amy Friend: [00:20:33] Throw.
Hannah McCarthy: [00:20:34] Them into the mix with less risky mortgages.
Nick Capodice: [00:20:38] Well, it's like using a bad cut of meat to make a stew. But all these packages get grades, though, right? So wouldn't that lower the grade of the bond if there's a bunch of risky mortgages bundled in it?
Hannah McCarthy: [00:20:49] It should, but it doesn't. The ratings companies started rating these mixed bag bonds as triple A's, even if they had a bunch [00:21:00] of risky mortgages in them. Like even if you've got some Triple A's and then a bunch of triple B's.
Nick Capodice: [00:21:06] But that's a lie, isn't it? He's building houses on sand. Literal houses.
Hannah McCarthy: [00:21:11] Yeah. You're not the only one who had second thoughts about this approach.
Amy Friend: [00:21:14] So then these investment banks said, Well, just in case something blows up, we need insurance, right? So that if they blow up, we get paid. So that was something called a credit default swap.
Nick Capodice: [00:21:29] Okay. That is a weedy swamp of words right there.
Hannah McCarthy: [00:21:32] Yeah. And it's also words that the average American shouldn't really have to think about. Right. But I'm trying to explain this. It's just insurance. All right? The investment bank said, you know, just in case this whole thing doesn't work out. Cough, cough, let's get insurance. You know, And a company called AIG, American International Group is the one who issued most of that insurance. Meaning if people stopped paying their mortgages, AIG would make insurance payments so that the investors and [00:22:00] the Wall Street firms would be just fine. And then AIG would also be just fine because it could just take Suzy Homebuyer's house back and sell it. And because home values are always on the rise, everyone wins. Aside from Susie Homebuyer, but who cares about her?
Amy Friend: [00:22:17] So what happens? How did the bubble burst? Right? Because there was so much money and prices went up and up and up and up, particularly in certain regions in the country.
Hannah McCarthy: [00:22:26] And when housing prices skyrocket. Right. And they keep rising, people are like, oh, we better get a house right now. And it's easy to do it for everybody because anybody can get a mortgage. And, you know, everyone is being encouraged to get a mortgage. Also, housing stock was rising because there was so much demand. Contractors were building and building. And all of this, Nick, all of these little factors, the predatory lending, the quote unquote, liar's loans, the triple-A ratings on risky mortgage bonds, the housing [00:23:00] prices, it was all too much.
Amy Friend: [00:23:03] It was unsustainable. The value was not there and the borrowers simply couldn't pay off.
Hannah McCarthy: [00:23:10] Right. So the loans reset. A loan. Resetting, by the way, means a new interest rate kicks in, typically a higher one.
Amy Friend: [00:23:19] So that first interest rate, well, maybe they were okay for a couple of years and then it went up and they couldn't pay. And you know what? The bubble burst and then they were left with something called an underwater mortgage, which is where the house value no.
[00:23:37] Longer supported the value of the mortgage. So the mortgage was higher priced than the underlying house that was supposed to support that.
Amy Friend: [00:23:47] So people couldn't sell and they couldn't refinance to get better terms. And so a lot of people people walked away. People struggled. So so when they stop paying [00:24:00] what happened to these bonds, they went bust. So the investors weren't getting paid. And then what happened? What why did the rating agencies give them these high ratings? And then when they went to AIG to get paid on their credit default swap, all of a sudden AIG finds that it's tremendously exposed on the other side of this deal to a lot of these big companies. And they didn't have the money to pay out. So this whole financial engineering, which was a way to pass off the risk to somebody else and diffuse it like insurance. So it spread around. It ended up concentrating the risk and all of these. Companies became interconnected and they just. It was a house of cards and it all fell apart.
Hannah McCarthy: [00:25:02] So [00:25:00] what happens when homeowners can't pay their mortgages? Which means that these bonds that were sold as very good. Prove themselves to be very bad. And the investors who bought these bonds learn their investment is worthless. And the insurance company who promised to take care of the fallout if the bonds did prove to be worthless doesn't actually have the money to do it. And the houses that would have provided that value don't actually have the value. Everyone was pretending they had a catastrophe. And who do we at least try to look to in times of catastrophe? The federal government. That's after the break here on Civics one on one.
Nick Capodice: [00:26:01] And [00:26:00] I started out confused. Now I am madly in love with the housing crisis. But before the break, I just want to tell listeners if you like us or if you've got issues with us. Leave us a review on Apple Podcasts or wherever you listen to your podcast. We read every single one. We take each one to heart and it helps us understand how to make the show better. Just do it. All right. All right.
Hannah McCarthy: [00:26:27] We're back. You're listening to Civics one on one. And on this episode, I have endeavored to explain the financial crisis that sent homeowners, mortgage lenders, investment banks, investors and insurers into a tailspin.
Amy Friend: [00:26:38] That is what happened in 2008.
Hannah McCarthy: [00:26:41] Again, this is Amy Friend, an expert in banking and consumer protection law, who in 2008 had recently taken a job as the chief counsel for the Senate Banking Committee. And what happened is that due to a series of really poor decisions by some of the biggest financial institutions in the country, the bottom fell [00:27:00] out of the economy. Housing prices plummeted. People could not pay their mortgages. And these giant institutions found that many of their holdings, as in billions of dollars worth of subprime mortgages, were pretty much worthless. You had Fannie Mae.
Amy Friend: [00:27:18] And Freddie Mac, right. Which are basically keep the housing market going. They buy a lot of these. They buy a lot of loans from banks.
[00:27:27] From other lenders to keep liquidity so that the lenders can keep making.
Nick Capodice: [00:27:32] Loans. Okay. I've watched so many presidential debates and I nod vigorously whenever somebody yells about Fannie Mae or Freddie Mac, I don't know who they are. Also, what is liquidity?
Hannah McCarthy: [00:27:41] Let's do liquidity first, because I think that's like fairly straightforward. Think liquid, literally something's ability to flow. That's what liquidity means. Now just apply it to cash. Fannie Mae is a company that was started by Congress to help ensure that mortgage money could flow after the Great Depression.
Nick Capodice: [00:27:58] I've heard those names Fannie [00:28:00] Mae and Freddie Mac so many times. But like, who are they? Why are they called that?
Hannah McCarthy: [00:28:04] It comes from the initialism federal National Mortgage Association.
Nick Capodice: [00:28:09] No, that's not possible.
Hannah McCarthy: [00:28:11] Oh yeah. Fma.
Nick Capodice: [00:28:13] I can't believe I didn't know that.
Hannah McCarthy: [00:28:15] Fannie Mae and then Freddie Mac, a.k.a. Federal Home Loan Mortgage Corporation. Fme CC It came around in the 1970s, also started by Congress so that Fannie Mae would not have a monopoly.
Nick Capodice: [00:28:30] A monopoly on keeping mortgage money liquid.
Hannah McCarthy: [00:28:33] Yeah, pretty much. They acted very similarly to the way that Janet Wall Street acted. They buy mortgages from lenders, they package them and they sell them to investors, and that allows lenders to hold on to their cash and keep making loans.
Nick Capodice: [00:28:49] Which I assume is part of.
Hannah McCarthy: [00:28:50] Liquidity. It is. And the big difference with Fannie Mae and Freddie Mac is that because the government started, although did not own them, investors [00:29:00] thought of the mortgage bonds they were buying from Fannie Mae and Freddie Mac as being guaranteed by the government. Right. So no matter what happens, this is safe because the federal government is behind this investment.
Nick Capodice: [00:29:12] So if Susie Homeowner doesn't make his mortgage payment, the federal government is going to step in and ensure that I still get my money.
Hannah McCarthy: [00:29:20] Yeah, this was never actually written down anywhere. It was just like the perception of any massive.
Nick Capodice: [00:29:25] Agreement they're going to they're going to cover.
Hannah McCarthy: [00:29:27] Yeah, Yeah. And the issue is that Fannie Mae and Freddie Mac, they also got in on the subprime mortgage by, oh.
Nick Capodice: [00:29:36] This is a disaster.
Hannah McCarthy: [00:29:37] They bought a lot, Nick. They bought a lot. The problem is they did not have the money to back it up. So the federal government does do something.
Amy Friend: [00:29:47] Their regulator put them into conservatorship and basically said you're going to be under government control right now because you don't have adequate capital to to function. This was around Labor Day of 2008. [00:30:00]
Nick Capodice: [00:30:00] A conservatorship like, you.
Hannah McCarthy: [00:30:03] Know, yeah, a conservatorship, which means managing the financial affairs of these companies. But yes, as in what happened to Britney Spears. Okay. But also, what does that really mean? It means the federal government decided, you know what, we cannot let Fannie Mae and Freddie Mac go under. They are behind way too many mortgages, way too many investments, Too much money is involved here. If they fail, it could mess up the whole economy.
Nick Capodice: [00:30:32] As in they are too big to fail.
Hannah McCarthy: [00:30:34] Yeah, too big to fail. To the tune of $191 billion in taxpayer money. But somebody who we met earlier was not too big to fail.
[00:30:46] Lehman Brothers, which was a huge investment bank that turned out to be.
Amy Friend: [00:30:51] Overexposed with these bonds and basically couldn't go to.
[00:30:56] The market and get anybody to fund them. On the other side, there was a lack of [00:31:00] trust. They were allowed to fail. And then AIG was bailed out.
Nick Capodice: [00:31:05] Why Lehman Brothers and not AIG?
Hannah McCarthy: [00:31:07] That is a question that still rages today. The Federal Reserve says Lehman could not get their hands on enough collateral to justify a loan from the government. Right. Like a house is a piece of collateral for the home buyer. They can always say, I've got all this value behind me. Lehman Brothers couldn't prove that they had enough collateral. Nobody wanted to invest in Lehman Brothers because everything was falling apart. And some say that not bailing out Lehman Brothers was actually a big mistake.
Amy Friend: [00:31:34] So it just looked like chaos, like somebody put under government control than another company is allowed to fail. Then another company is bailed out. And then the chairman of the Federal Reserve Board and the treasury secretary came to Congress and said, you have to help out because we cannot deal with this anymore and you need to provide $700 billion to prop up the financial system [00:32:00] or the financial system in the United States will collapse and will bring the global economy down with it. And you've got a week to put this together.
Nick Capodice: [00:32:16] A week. Since when does Congress agree on a number like that? In a week.
Hannah McCarthy: [00:32:22] Okay. Something that we need to keep in mind here is that all of these US investment banks are tied to the global economy. It's not just the US. I mean, the pressure was on Nick. This was really bad. I just I want you to understand like this was devastatingly bad. This is Great Depression too, but worse.
Nick Capodice: [00:32:46] Wow.
Amy Friend: [00:32:48] It was shocking. Shocking. It's like the most, you know, respected financial system in the world with with all of the you know, [00:33:00] it was well regulated. And, you know, people flock to the United States as a safe place to put their money. And the dollar is the reserve currency for the world. And here we are. It was our crisis that was exported to other parts of the world, and the financial crisis was contagious. And it started in the United States. And it was just it was truly shocking that it fell apart as quickly as it did. And to hear, you know, Senator Dodd come back from this. There was a meeting in Speaker Pelosi's office.
Hannah McCarthy: [00:33:37] Senator Christopher Dodd, chairman of the Senate Banking Committee, which Amy works for.
Amy Friend: [00:33:42] Chairman Bernanke, had been a sort of he studied the Great Depression and taught it at at Princeton. And he said this will be worse if you don't jump on this. This will be worse because the world is so much more interconnected than it was in 1929. And I know that we have [00:34:00] to have an overwhelming, aggressive action here in order to stem the hemorrhaging.
Nick Capodice: [00:34:09] Okay. So it really is, like you said earlier, save the companies, save the world.
Hannah McCarthy: [00:34:14] That was the calculation.
Amy Friend: [00:34:15] Well, very short period of time to put together the immediate reaction to the crisis, which was this $700 billion called the Emergency Economic Stabilization Act, or TARP, which was the Troubled Asset Relief Program, which is what Treasury came to the Congress and asked for. But it ended up morphing into something quite different.
[00:34:39] But it was very successful program and stood side by side with a number of other actions that the regulators took.
Hannah McCarthy: [00:34:48] All right. I'm going to give you the barest of glancing blows of TARP here, just so you understand what they could possibly need. That $700 Billion for 250 billion for making sure giant investment banks didn't go under 27 [00:35:00] billion to get credit markets going again.
Nick Capodice: [00:35:02] Credit markets.
Hannah McCarthy: [00:35:03] Okay. When you own a house, you own collateral. We've been over that, right? When the price of your house drops, your personal wealth drops, and it is harder to get a line of credit, It's harder to get a loan based on the value of your house. That's part of the credit market. And it froze up. Then $82 billion goes to the auto industry to get that going again.
Nick Capodice: [00:35:23] How does the auto industry figure into this at all?
Hannah McCarthy: [00:35:25] Did I not mention that oil prices went up 50% and then the oil market crash? And also nobody was buying cars because their main source of wealth and credit, a.k.a. their homes, had lost value? Nick, I keep telling you, everything was horrible. Everything was falling apart. Aig gets 70 billion. That is a part of their eventual $191 Billion to get them stabilized and then 46 billion for the little guys, families facing foreclosure, which due to a long, awful history of credits and loans that we mentioned earlier, of course, disproportionately affected communities of color.
Nick Capodice: [00:35:59] And also [00:36:00] notably, the least money was going to the millions of affected Americans.
Speaker5: [00:36:05] It seems there's no good news when it comes to the housing market. Sales of existing homes plunged 8.6% in November as compared to October. It's estimated that 45% of sales of existing homes are foreclosed properties.
Nick Capodice: [00:36:17] So you've had a lot of your neighbors foreclosed on already.
Speaker6: [00:36:21] If you are watching us from the last home you'll ever own tonight, consider yourself lucky. Same goes for anyone ready to buy a slice of the American dream. But if you're among the millions trying to sell, this was a very bad day. So if there's somebody whose financial planning is based on their house price coming up in value soon, you're saying maybe they should come up with another plan? Exactly. I mean, there's absolutely no reason to expect that prices are going to go back to the levels they were at three or four years ago.
Amy Friend: [00:36:50] One interesting lesson from the Great Depression was that government needed to act speedily. And the Federal Reserve Board, [00:37:00] which was created in 1913 to address panics. Right. Did not step up in the Depression, but this time stepped up in a huge way.
Hannah McCarthy: [00:37:11] Basically, the government knew that the whole financial system would freeze up if they didn't do something, because that is what happens in a situation like this. So the Fed said, All right, we will buy these assets from these companies that nobody wants right now in order to keep the system functioning. And if you're hearing this and thinking, wait, so this is very much a massively capitalist based issue, you are correct and welcome to America.
Nick Capodice: [00:37:38] So we talk about bailouts. What's actually happening here is that the Fed is buying these worthless assets from these investment banks because they can't get anybody else to buy them.
Hannah McCarthy: [00:37:49] Yes. All right. So, okay, that is the emergency response, right? That is what came first. That's what Congress pulled off in a week. But that was not enough. The [00:38:00] answer to the financial crisis was not simply throw money on the fire.
Amy Friend: [00:38:04] Dodd-frank was the longer term. How do we fix the system now that we were forced to bail it out? How do we.
Nick Capodice: [00:38:14] Make sure that doesn't happen again? I have heard of Dodd-Frank, and I assume this is partially named after Senator Christopher Dodd. He mentioned earlier.
Hannah McCarthy: [00:38:21] Sure is. And Amy is in the room for all of it.
Amy Friend: [00:38:24] The Senate Banking Committee staff started working on ideas in October, November 2008 and talking to a lot of experts and putting experts before the members of the committee to start to think about how do you create a system of reforms going forward to ensure as best possible that we don't face the same failings and that make the system resilient enough so that they can withstand something [00:39:00] unanticipated? So we were working on that in the fall of 2008.
Hannah McCarthy: [00:39:07] So then Barack Obama gets. Elected and his administration is like, we really want to show the world that we have a good plan because we messed up big.
Speaker6: [00:39:17] And many, many Americans are both anxious and uncertain of what the future will hold. Now, I don't believe it's too late to change course, but it will be if we don't take dramatic action as soon as possible. If nothing is done, this recession could linger for years.
Hannah McCarthy: [00:39:36] So what's the plan? Give us the plan. We've got this big global meeting coming up and we have got to show them that we know what we're doing. We're going to fix this.
Amy Friend: [00:39:44] So they were pressing Congress to try to do something by April of 2009, which no, there was no way this was such a huge undertaking. But I remember that the chairman of the House Financial Services Committee, Barney Frank, and the chairman [00:40:00] of Senate Banking, Senator Dodd, put together a letter to President Obama saying that we are working in earnest and we will pass something so that they could go to this international meeting and say, you know, we're going to clean this up, because, again, it was the US that was responsible for something that was then in basically.
[00:40:19] Bleeding out into into the other parts of the world.
Hannah McCarthy: [00:40:26] And this is what it ended up looking like a gigantic bill, the Dodd-Frank Wall Street Reform and Consumer Protection Act. Here is what it basically said. First thing, we're going to have consumer protection.
Amy Friend: [00:40:41] It creates a new Consumer Financial Protection Bureau to look at financial services through the eyes of the consumer, through the eyes of the borrower. Right. So through the eyes of the consumer that is getting [00:41:00] a financial product or service in a way that hadn't been done during the crisis. Right? I think the bank regulators were largely looking at it from the perspective of the bank, and it looked like these things were safe and sound because they were profitable. But if you stopped and looked at it from the consumer's perspective, which is they're getting these loans that they can't afford, it's like a canary in the coal mine.
Hannah McCarthy: [00:41:27] Next, regulators.
Amy Friend: [00:41:29] It created a council of regulators. It's called the Financial Stability Oversight Council to look across the whole financial system because we have a lot of financial regulators that focus on different parts of the system.
Hannah McCarthy: [00:41:46] A major question that some people me I am the some people may have about this whole thing is why didn't anybody see that this was happening? And the answer is that we did not have a robust system of regulators [00:42:00] who were watching for systemic breakdown due to bad behavior on the part of financial institutions. So now this Council of Regulators meets with Congress annually to report on risks they see in the system. Dodd-frank also came up with a plan for companies who obviously need some oversight. Basically, the Federal Reserve is now allowed to take a company under its wing for a while. The long, slow bankruptcy process for Lehman Brothers proved to the government that the system, as in the bankruptcy system, is not designed to handle the disintegration of a giant, multibillion dollar multinational company. Also, when something that giant and interconnected fails, as we've seen, it has the potential to take the whole system down with it. So now the government says, you know what, you actually can fail, but you have to have a plan for how to do [00:43:00] it without ruining everyone's lives.
Amy Friend: [00:43:02] In fact, these companies all have to submit on a regular basis plans for how they could be unwound so that if the FDIC, the Federal Deposit Insurance Corporation, which would be the entity that resolves them, has to ever step in, they at least have a roadmap.
Nick Capodice: [00:43:19] Wow. So it's like these companies all have to write a last will and testament in the event of my death. Here is how things will go. Also, what does Amy mean by moral hazard?
Hannah McCarthy: [00:43:30] She said that if the market sees that Congress is just going to bail out companies when they make mistakes, those companies are just going to keep making those mistakes.
Amy Friend: [00:43:38] And that's the argument that we're going on, on different sides of just the foreclosure relief. And that's what the arguments that were going on in propping up the failed system in the Emergency Economic Stabilization Act that was preceded than the Dodd-Frank Act. So these were common themes that were playing [00:44:00] out. And I would say it was largely the Democrats that were in favor of more aggressive foreclosure relief and the Republicans who were arguing for market discipline.
Hannah McCarthy: [00:44:10] Okay. And then Dodd-Frank also said, look, giant financial institutions, you cannot end up in a spot like this again. You cannot leave yourself so exposed to possible failure, giant company. You have to make sure you have a ton of capital, as in total wealth and assets before you can mess around with loans and investments. And this, Amy says, is a super important part of Dodd-Frank.
Amy Friend: [00:44:33] And so there's more capital in the system, there's more liquidity. So if you have some kind of event like a stress, like the pandemic where companies were failing, right, the financial system was strong and that was a result of all of these reforms that were put into place, though the financial system was a source of strength for the economy as opposed to a drain on the economy. In the financial crisis. [00:45:00]
[00:45:00] In 2008, the financial system was a drain on the economy during the.
Amy Friend: [00:45:04] Pandemic, when small businesses were closing and people were going out right, there were layoffs and we saw it. Everything. Unemployment go up, the financial system stood strong. So so there's more liquidity, there's better risk management, there's more capital in the system.
Hannah McCarthy: [00:45:20] Amy actually says that the COVID 19 pandemic, which happened only ten years after Dodd. Frank was passed was the ultimate test of whether or not the system really had been strengthened.
Nick Capodice: [00:45:37] Okay. But I do remember that this whole effort on Congress's part was not exactly popular. Right. The public was openly furious with Congress for bailing out the banks, for propping everything up while the homeowners suffered.
Hannah McCarthy: [00:45:53] It's our duty as Americans to fight for our country and to keep it, you know, true to serving its people. And when it doesn't [00:46:00] do that, it's immoral not to stand up and say something.
Nick Capodice: [00:46:04] I'm here myself as a free individual to humanize the markets and to have true participatory democracy, bottom up democracy, and to make.
Amy Friend: [00:46:15] I think there is not a whole lot of understanding amongst the general public about what Dodd-Frank does. A lot of the provisions are complicated, esoteric. People don't talk about credit default swaps. Nor necessarily should they. Where the public emotion ran very high was in the emergency response in TARP, which was a perception that Congress was bailing out Wall Street and and forgoing assistance to Main Street.
Nick Capodice: [00:46:55] Can I can I just break in here for a second and say that I have no idea what the whole Wall [00:47:00] Street versus Main Street thing means? Am I Main Street or we Main Street?
Hannah McCarthy: [00:47:04] I think the best way to think of it is Main Street means all of us Americans who are not a part of this wildly money filled, gigantic financial institution world, people who stand to lose their smaller businesses, their jobs, their homes, their ability to feed and clothe themselves and their families, I mean, their whole life savings, etc.. If Wall Street screws up. Amy says that in Congress, the idea was if we bail out the banks, then they'll be able to support Main Street. They'll be able to get lines of credit going again. Homeowners and business owners will be able to survive. And let's be clear here. This could alternatively be labeled as a trickle down economics theory. And a lot of voters did not agree with it because that's what it appeared to be. And Congress did not do a great job of explaining it.
Amy Friend: [00:47:56] Had there been some more focus [00:48:00] and more sort of conversation about this is foreclosure relief for homebuyers, as well as we're keeping the banks going so they can support Main Street. But it was never popular. Members of Congress, senators, congressmen lost their seats for voting for TARP. But I know the firm belief was if this went down, the system could go down. And we can't we can't afford that. Even if the public sentiment is not supporting this, we have to step up because it's the right thing to do. And I believe it was the right thing to do. But people still debate that.
[00:48:39] So Dodd-Frank, which was more of the long term, how do you make the system sound? It definitely.
Amy Friend: [00:48:46] Has its detractors.
[00:48:47] But I would say most members of the public don't understand or would take the time to really understand the different aspects of it. I think they.
Amy Friend: [00:48:57] Just want the government to [00:49:00] have to stand behind a system.
[00:49:03] That is sound and that's fair. And that is what Dodd-Frank.
Amy Friend: [00:49:08] Is meant to do, which is to create this system that is resilient, that will treat customers, consumers, borrowers, investors fairly, and that will hold financial firms to high standards. That's what.
Hannah McCarthy: [00:49:22] Dodd-frank does. So one thing I have to make very clear, and it probably already is, is that Dodd-Frank and TARP and everything about the response to the 2008 financial crisis is, of course, political. And Amy is obviously a fan of Dodd-Frank. Not everybody is. But to her point, and this was certainly true of me before I made this episode, not many people understand what Dodd-Frank is. And when I tried to read its nearly 850 pages. I tried. I couldn't. I couldn't do it. And that could in itself be a problem. But I also suppose that's [00:50:00] laws for you. I do appreciate, however, this point that she made about the whole quote unquote market, because the story of the financial crisis still has me thinking, wait, but how did this happen? And the how this happened is what Dodd-Frank attempts to fix. You know, there is this sentiment.
Amy Friend: [00:50:20] That the market should largely policed itself, but the market blew up. I mean, the market was so focused on making money and had believed that they so engineered this disbursement of risk that nobody would be left holding the the, you know, the bag.
Nick Capodice: [00:50:41] And it just blew up. Hold on. What is the actual answer to the question? How did this happen? We have a lack of regulation, and I get that. But what was underneath the unregulated surface before 2008? I mean, is the answer just everybody wanted to get rich.
Hannah McCarthy: [00:50:59] Yeah.
Nick Capodice: [00:51:00] That's [00:51:00] it. And we can maybe get away with it.
[00:51:04] So there was just an incredible drive to make money. And, you know, and the question was, well, where were the regulators? And like, what were they doing? And so some of these activities were outside of the regulated space. And then when they went into the banks, I think the.
Amy Friend: [00:51:22] Regulators also miscalculated and thought, well, the banks are all making money, so this must be safe and sound. Never really looking from the consumer's perspective of, well, these don't have sound terms, so banks should not be anywhere close to them.
[00:51:37] They shouldn't be buying them, packaging them, funding them. They shouldn't be involved in this. And that never happened.
Hannah McCarthy: [00:51:50] When I was a kid and learning about the Great Depression, my mom told me, Don't worry about a kid. That could never happen again because the government has ways of preventing that now. But [00:52:00] the truth is it did not. And there was a massive panic and the government had to devote billions and billions of taxpayer money and pass a massive piece of legislation to deal with that panic. So now here's the question. Could it happen again? Again? You know, the idea behind.
Amy Friend: [00:52:19] Dodd-frank was not just to address the problems of the past because you don't know the ones that are coming up. Right. So, for instance, nobody saw a global pandemic. That would be a stress on the economic system. So the idea was to also create this 21st century financial system and set of regulations and regulatory actors that could take on new challenges. So one of the things that I think we see emerging is that climate change is actually a risk to the financial system because financial actors are quite exposed when it comes to climate change. So they're making [00:53:00] loans in areas that are subject to constant droughts or floods or fires. Right. And then there's something called transition risk, where as the economy moves away from fossil fuels to more renewable energy, what about investments and loans to all of these fossil fuel companies when we're heading towards net zero? So, you know, it's managing these risks. Cryptocurrency, right? So is that systemic? So I think what's important is that Dodd-Frank did not just address like the ills of the past, but it also gives the regulators the tools to deal with emerging issues. I think ultimately, the success of Dodd-Frank, you know, in the long run is did it make the system more resilient and provide the tools that regulators need to deal with emerging issues? And so far, I would say the answer is yes.
Hannah McCarthy: [00:53:59] So [00:54:00] obviously, Nick, Dodd-Frank did not arise out of one of these unpredictable situations. It arose out of the purposeful and incredibly risky and ultimately completely disastrous behavior of financial institutions who were not being watched closely enough. But Amy's point is that with Dodd-Frank in place now, the system is ultimately at less risk in any number of potential disastrous situations.
Nick Capodice: [00:54:25] It would have been nice if we could have had all that without attending the school of hard knocks.
Hannah McCarthy: [00:54:29] Wouldn't it, though? In this episode of Civics 101 was produced by me, Hannah McCarthy, with help from Nick Capodice. Christina Phillips is our senior producer. Jacqui Fulton is our producer and Rebecca Lavoie is our executive producer. Music [00:55:00] In this episode by Roof, Charles Valentin Alkin, ISO Indies and Ketsa. You can find this whole episode and all of our others on our website, civics101podcast.org. And if you enjoyed this episode or if you did not leave us a review, your feedback makes us better and we take it very seriously. Civics 101 is a production of NHPR, New Hampshire Public Radio.