Like the Andromeda strain, the subprime meltdown went viral, and it ended up infecting almost all aspects of the economy. Financial institutions were the first to fall. Many originating firms had not sold all of their subprime mortgages, and they failed. For example, New Century declared bankruptcy in 2007, IndyMac was placed
under FDIC control in 2008, and Countrywide was acquired by Bank of America in 2008 to avoid bankruptcy.
Securitizing firms also crashed, partly because they kept some of the new securities they created. For example, Fannie Mae and Freddie Mac had huge losses on their portfolio assets, causing them to be virtually taken over by the Federal Housing
Finance Agency in 2008. In addition to big losses on their own subprime portfolios, many investment banks also had losses related to their positions in credit default
swaps. Thus, Lehman Brothers were forced into bankruptcy, Bear Stearns was sold to JPMorgan Chase, and Merrill Lynch was sold to Bank of America, with huge losses to their stockholders.
Because Lehman Brothers defaulted on some of its commercial paper, investors in the Reserve Primary Fund, a big money market mutual fund, saw the value of its investments “break the buck,” dropping to less than a dollar per share. To avoid panic and a total lockdown in the money markets, the U.S. Treasury agreed to ensure some investments in money market funds.
AIG was the number one backer of credit default swaps, and it operated worldwide.
In 2008 it became obvious that AIG could not honor its commitments as a counterparty, so the Fed effectively nationalized AIG to avoid a domino effect in which AIG’s failure would topple hundreds of other financial institutions.
In normal times, banks provide liquidity to the economy and funding for credit-worthy businesses and individuals. These activities are absolutely crucial for a well-functioning economy. However, the financial contagion spread to commercial banks because some owned mortgage-backed securities, some owned commercial the paper issued by failing institutions and some had exposure to credit default swaps.
As banks worried about their survival in the fall of 2008, they stopped providing credit to other banks and businesses. The market for commercial paper dried up to such an extent that the Fed began buying new commercial paper from issuing companies.
Banks also began hoarding cash rather than lending it. The Fed requires banks to keep 10% of the funds they raise from depositors on “reserve.” Banks use the other 90% to make loans or to buy securities. In aggregate, there usually has been about $9 billion in excess reserves—that is, reserves over and above the 10% they are required to keep on hand. However, at the end of 2008, banks held over $770 billion in excess reserves compared to $75 billion in required reserves. This hoarding may have reduced the banks’ risk, but it deprived the economy of a much-needed capital.
Consequently, there has been a reduction in construction, manufacturing, retailing, and consumption, all of which caused job losses in 2008 and 2009, with more expected in the future. In short, this has led to a serious recession in the United States and most of the developed world, a recession that brings back memories of the Great Depression of the 1930s.
