The 2008 Crisis & The Fed’s Response

Unlike many of the previous financial crises we described, the 2008 financial crisis was one that you lived through, even if you were just a kid at the time, and perhaps even faced the consequences of.

The financial world, or more accurately, the world at large, was never the same after the 2008 financial crisis. If it were not for the crisis, Bitcoin might not exist today, and the monetary revolution that is crypto might have been forestalled a little bit longer.

So it is worth spending a little time understanding what happened during the 2008 financial crisis, and why the events during this period led to a strong growth in a counter-movement and counter-culture: crypto.

By now we have spent a great deal of time understanding how the housing bubble got so big that it eventually popped.

What came after the pop was the most severe recession the US has endured since the Great Depression.

The crisis

During the Great recession, the default rate on mortgages skyrocketed, resulting in many foreclosures.

SOURCE: FEDERAL RESERVE LECTURES BY BERNANKE

Recall that a financial panic is when providers of short-term credit (i.e., depositors in a bank) suddenly lose confidence in the ability of borrowers (i.e., banks) to repay a loan. Once short-term creditors lose confidence, they try to withdraw their funds as quickly as possible.

As the value of mortgage-backed securities declined in 2008, buyers evaporated, and banks who were heavily invested in these assets suddenly faced a crisis. As house prices fell, it became clear that mortgage-related securities were on the verge of tanking.

​However, it was unclear where the losses would fall because of how complex the financial market had become (we will see an example below).

Soon enough, bank runs began as investors started pulling their money from any firm they thought was vulnerable to losses. This created enormous pressure on big financial firms.

Some of the large financial firms that came under intense pressure in 2008 included:

Bear Stearns, which ended in a forced sale.

Fannie and Freddie Mac, which was placed in conservatorship, meaning their liabilities would be guaranteed by the U.S. Treasury. The government felt this had to be done to prevent further worsening of the crisis. Countries all around the world held hundreds of billions of loans. A collapse of Fannie and Freddie would not end well for anyone.

Lehman Brothers, which filed for bankruptcy.

Merrill Lynch, which was acquired by Bank of America because it was going under.

AIG, which received emergency liquidity assistance from the Fed.

Washington Mutual Bank, which was closed by regulators and later acquired by JP Morgan Chase.

Wachovia, which was failing and then saved by the acquisition of Wells Fargo.

This is just the tip of the iceberg. There were a LOT more bank failures and madness, which we won’t have time to get into in this post.

This was very different from the Great Depression because in the 1930s, it was mostly small independent banks that failed. In 2008, the banks were much bigger and far more intertwined.

To better understand this, let’s look at an example of how the failure of Lehman Brothers caused the entire financial economy to collapse on itself.

Money market funds and commercial paper market

Money market funds (MMFs) are companies that invest in highly liquid, near-term assets (e.g., commercial paper, cash, cash-equivalents, short-term debt instruments, etc.) and then sell shares of their investments to buyers.

MMFs historically have almost always maintained stable $1 share prices.

Although MMF shares are not insured, they are still considered extremely low-risk on the investment spectrum. Investors use MMFs like checking accounts and expect to be able to earn interest and redeem shares on demand for $1.

One common asset that MMFs invest in is commercial paper (CP). CP is a short-term (typically 90 days or less) debt instrument that companies issue and then use to pay for immediate expenses such as payroll and inventories. Financial institutions use CP to raise funds that they then lend to ordinary businesses and households.

SOURCE: FEDERAL RESERVE LECTURE SERIES BY BERNANKE

The Lehman Brothers catastrophe

Lehman Brothers was a global financial services firm that was once considered the gold standard financial firm. During the 2000s, Lehman invested extensively in mortgage-related securities and commercial real estate and relied on CP to fund these investments.

But as the housing market started to collapse on itself, Lehman’s mortgage-related investments started to show massive losses. Lehman’s creditors lost confidence and started to withdraw their money from the fund. The losses were so big that Lehman could neither find new capital (because people lost faith in the firm) nor could they find another firm to acquire it.

On September 15, 2008, Lehman filed for bankruptcy, sending a massive shock throughout the financial system.

The Run on MMFs

After the collapse of Lehman Brothers, one of the many MMFs that issued CP to Lehman failed to maintain a $1 share price. This had a cascading effect on other MMFs because investors started to lose confidence in MMFs and rushed to redeem their money.

Seeing the crisis brewing, the Treasury offered a temporary guarantee of the value of MMF shares.

Also rendering assistance, the Fed created a program to provide emergency liquidity by lending to banks, which in turn provided cash to MMFs by purchasing some of their assets.

The combined efforts of the Treasury and the Fed helped to eventually cease the run on MMFs, but it took time.

SOURCE: FEDERAL RESERVE LECTURE SERIES BY BERNANKE

The CP market started to fall apart

The MMFs responded to the run on MMFs by curtailing their purchases of commercial paper. As a result, the demand for CP dried up, and interest rates on CP soared. This meant the cost of credit went up, which affected both businesses and households.

SOURCE: FEDERAL RESERVE LECTURE SERIES BY BERNANKE

So in effect, the collapse of Lehman led to a run of MMFs, which then led to CP markets drying up, which had dire consequences on businesses and households. This is an example of a financial crisis caused due to interconnected financial systems. When everything is intertwined, if one thing goes wrong, a domino effect is never far-off from happening.

The Federal Reserve established special programs to repair functioning in the CP market and restart the flow of credit (which we will talk about in the next post).

The crisis spread around the world

The US represented over one-third of the global consumption between 2000 to 2007. Thus, the world depended on US consumer demand, and therefore the economic crisis that started in the US rapidly spread globally.

Moreover, the toxic securities sold during this period were not just owned by US investors. They were also owned by international investors. Complex derivatives (e.g., CDOs) made the situation worse because these products create an even greater linkage between so many different parts of the financial system.

As markets started to collapse and firms started to deleverage, international trade declined and developing countries saw their growth tank.

It was not a pretty scene at all. Cue the splat.

Economic consequences of the crisis

​1) Financial stress skyrocketed

SOURCE: FEDERAL RESERVE LECTURE SERIES BY BERNANKE

2) The stock market plunged

SOURCE: FEDERAL RESERVE LECTURE SERIES BY BERNANKE

3) Home construction continued its sharp decline

SOURCE: FEDERAL RESERVE LECTURE SERIES BY BERNANKE

4) The unemployment rate rose sharply​

SOURCE: FEDERAL RESERVE LECTURE SERIES BY BERNANKE

…the list goes on.

The crisis is too big and too complex to summarize in a single lesson, but I hope this gives you the starting point to understand just how complex and intertwined the modern financial system is. If you are interested in digging deeper, I highly encourage you to do more research on your own. The time spent understanding the 2008 financial crisis will help put a lot things (in relation to crypto) in perspective for you.

I hope by now that you are starting to understand why a more transparent and less centralized system is necessary for building a resilient economy. The modern financial system is effectively a house of cards waiting to collapse at any moment. There are no checks and balances in place to keep the various actors in check, and so the bankers end up being incredibly greedy and taking big risks knowing that they will always get bailed out by the Fed and government. And this is a big part of what crypto hopes to change. It is a monetary system with checks and balances built into the system (i.e. strong incentives).

Next, we’ll learn about how the Fed responded to the 2008 crisis (hint: QE).

By now you understand, based on all the previous posts, that the Fed’s core responsibility is to prevent financial panics and/or come to the economic rescue as needed. The panic of 2008 threatened the stability of the global financial system at large, necessitating a large-scale intervention by the Fed.

In this post, we will take a look at some of the different things the Fed did to carry out its duties and help calm matters in 2008.

Special liquidity and credit facilities

Recall that one of the Fed’s primary roles is to be a lender-of-last-resort when banks and financial institutes are failing. Lending freely to failing banks is intended to help halt bank runs and restore the market. In 2008, the Fed worked closely with the Treasury and other regulatory agencies, such as the FDIC and SEC, to provide liquidity to firms that were failing.

The Fed launched a series of different funding programs that you can read about in detail here. In essence, the Fed loaned money out to thousands of struggling financial institutions and businesses that used their solvent assets as collateral to secure the loans. Since all the loans were collateralized, the risk of defaulting was believed to be low.

Moreover, the Fed also coordinated with foreign central banks to help the international markets, which were coming under a lot of pressure. The Fed provided temporary foreign currency swaps, meaning it gave dollars to other central banks in exchange for foreign currencies. These swaps allowed foreign central banks to fund their investments in dollar-denominated assets. The foreign central banks agreed to buy back their own currency at a specified future date at the same exchange rate that was used to make the original currency swap.

Overall, the lending programs were effective in stopping bank runs on various types of financial institutions. The programs also helped to slowly restart the flow of credit in the markets, which helped calm the panic.

As the financial system calmed down, it was no longer economically appealing for institutions to borrow from the Fed, so they naturally wound down on their own. The loans that the Fed gave out were eventually repaid in full, with interest.

All the 2008 lending programs that the Fed launched were phased out by March 2010.

Supporting critical institutions

The Fed also helped bail out large financial institutions such as Bear Stearns and AIG.

Bear Stearns

Bear Stearns, one of the largest financial institutions in the world, was on the brink of failure in 2008. If Bear Stearns collapsed, it would only exacerbate the dire economic situation.

J.P. Morgan’s willingness to buy out Bear Stearns gave the Fed some confidence that perhaps Bear Stearns remained solvent. For that reason, the Fed facilitated a loan for J.P. Morgan to take over Bear Stearns.

AIG

AIG is a multinational insurance and financial services firm that was facing serious liquidity problems in 2008 and was on the brink of failure. AIG sold insurance on bad mortgage-related securities, and when the mortgage market fell, everything (predictably) came crashing down.

Given that AIG was interconnected with many other parts of the global financial system, if the firm failed, it would have had a massive effect on the global financial market and global economy.

In order to prevent collapse, the Fed loaned AIG $85 billion in October 2008, using AIG assets as collateral. The Treasury subsequently lined up a $182 billion bailout for a 53% stake in the company.

Overtime, AIG stabilized and repaid the Fed with interest. The firm has since made progress in reducing the Treasury’s stake in the company.

A bad taste in everyone’s mouth

The bailout of AIG and Bear Stearns was not viewed as a positive by the public. For one, other companies that failed during the crisis weren’t rendered assistance, and this was viewed as unfair (because let’s face it, it is). Moreover, bailouts like this create very perverse incentives because if these large financial juggernauts know that they will be bailed out when things go south, they are not incentivized to use best practices and will instead continue to take dangerous risks.

However, the Fed and US Government felt that if the whole system collapsed, it would have a very serious impact on the US and global economy. Regardless of public perception, they felt this was the best way to right a sinking ship.

The problems at Bear Stearns, AIG, and other large financial institutions highlighted the need for a better way to deal with massive financial institutions that were on the brink of failure (hint: having a system where companies don’t get “too big to fail” in the first place).

Stress-testing financial institutions

Another way the Fed came to the rescue in 2008 was by leading stress tests of big banks in the US. The idea was that stress-testing the banks would give investors some confidence about these banks’ solid economic viability. In spring of 2009, the Fed led tests on 19 of the largest U.S banks.

These stress tests helped restore some investor confidence and allowed these banks to raise about $140 billion in private capital (rather than relying completely on the Fed and government for bailouts).

Reducing interbank rates

Another approach to helping calm the panic was to lower interbank rates, the interest rates banks pay to borrow short-term funds. On October 10, 2008, all of the G-7 countries agreed to work together to make this happen.

Reducing federal funds rate

As we learned in previous posts, the Fed lends to banks through a discount window. During the crisis, the interest rate (i.e. Fed funds rate) on discount window loans was drastically reduced. To make sure banks always had access to funds and prevent any potential panics, the Fed reduced the federal funds rate from 5.24% in September 2007 to nearly zero in December 2008.

​​Large-scale asset purchases (i.e., QE)

Despite dropping the federal funds rate to nearly zero, the economy was not recovering. However, the Fed had exhausted what it could do with monetary policy because the short-term interest rate was already nearly 0%. When interest rates are at zero, it creates a “liquidity trap” where people prefer to hold cash or very liquid assets because the return on lending their cash is so low. Therefore, the economy is at risk of entering a deflationary cycle where wages and prices fall.

The Fed, therefore, needed a plan B badly. Since lowering short-term interest rates to nearly 0% to help open up credit for large banks was not enough to induce a recovery, the Fed then sought out a way to reduce long-term interest rates (e.g., mortgages, corporate bonds, etc) as well.

In order to influence longer-term interest rates directly, the Fed decided to buy ample Treasury and government-sponsored enterprise (GSE) mortgage-related securities. This became known as “quantitative easing.” The more technical term for this is “large-scale asset purchases” (LSAPs).

The idea behind LSAPs is that when the Fed buys Treasuries and GSEs, it reduces the supply of these assets. Economics 101 tells us that if the supply goes down, then demand goes up. By buying up these securities, the Fed creates demand from investors, who are both willing to hold these securities and to accept lower yields.

With a lowered supply of Treasury and GSE securities, investors also started to purchase other assets like corporate bonds. This increased demand (and reduced supply) of corporate bonds reduced the yields on these assets as well.

The intended goal of reducing long-term interest rates was attained.

It’s interesting to understand how the Fed paid for all this. The Fed doesn’t have the funds to purchase these assets outright. Contrary to a common misconception, the Fed is NOT printing money willy-nilly to engage in quantitative easing. Instead, it credits the accounts of the banks banking with the Fed. This increases the amount of reserves that banks have. In other words, they purchase the assets with digital money and therefore do not affect the amount of money in circulation. Instead, they increase the digital balance of reserves in banks.

Overall, the LSAPs that happened between 2009 to 2010 boosted the Fed’s balance sheet by more than $2 trillion.

There is often a misconception that LSAPs are government spending. However, this is not the case either. The government uses fiscal policy (i.e., taxation) to acquire funds. In this case, the central bank uses “monetary policy” to engage in LSAPs.

The assets that the Fed purchased are ultimately sold back into the market. In fact, the Fed makes a profit on these LSAPs.

From 2008 to 2011, the Fed made $200 billion in profits through LSAPs, which were transferred to the Treasury (which arguably reduced the federal deficit).

Did LSAPs work?

LSAPs seemed to have lowered long-term interest rates. For example, 30-year mortgage rates fell below 4% after 2008.

Corporate bonds’ yield also fell, which allowed businesses to get credit more easily.

Did the economy recover though?

We could spend weeks (more likely months) analyzing the details of the Great Recession and the economy’s eventual recovery. For the sake of time, I will not go into that (because we need to get to the crypto part already!)

But I felt it was important for you to understand the types of actions that the Fed and government sometimes take to keep the economy afloat.

Overall, there is still a lot of controversy about what worked in 2008 and what didn’t. For better or worse, the Fed’s bailout actions likely did prevent the economy from reaching Great Depression levels.

However, who knows what would have happened if the Fed did not come to the rescue through quantitative easing. Would the story of the US have looked like Japan after the country’s bubble popped in 1991, and the economic recovery never really arrived?

Or would the market have eventually recovered to its pre-recession highs after a painful recovery period?

I will leave it up to you to ponder that particular mystery.

As you can undoubtedly tell from your reading thus far, the global financial crisis revealed the weaknesses in the financial system and the need for better regulation. The fact that large institutions like Lehman Brothers and AIG could cause the whole financial system to collapse was a serious weakness in the system. The financial world is highly intertwined and that is a necessary evil. In fact, this is even the case in today’s “DeFi” world. But one bad egg shouldn’t lead to the whole financial recipe being immediately scrambled.

The Fed and government strongly felt that more oversight of the system as a whole was necessary.

After many months of debate, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010 under the Obama Administration, which placed many new stringent regulations on the banking system. Moreover, several changes were made to how the Fed operates.

The Dodd-Frank Act

The Dodd-Frank act was a massive piece of financial reform that was 2,300 pages long and took several years to fully implement. It targeted key financial institutions that were believed to have caused the financial crisis, including banks, mortgage lenders, and credit-rating agencies.

The act made regulators responsible for tracking and responding to possible risks to the financial system as a whole.

Below are some of the regulatory reforms enacted:

• A “Financial Stability Oversight Council” (FSOC) was created to help regulators coordinate their efforts.
• The FSOC allowed the Fed to supervise nonbanking institutions and the stock exchange.
• Financial institutions had tougher supervision and regulation, such as:
• Higher capital requirements
• The Volcker rule, which restricted the ways banks can invest. Specifically, they were no longer allowed to trade on their own account. Banks were also not allowed to be involved with risky hedge funds or private equity firms.
• Regular “stress tests” were conducted to ensure banks could survive in a crisis.
• The act tried to tackle the problem of “too big to fail”:
• New “orderly liquidation authority” allowed the FDIC to close failing financial firms so that the firms could fail safely, without causing the entire system to collapse. To do this, an “Orderly Liquidation Fund” was created that provided liquidation and restructurings when companies needed to be propped up (instead of paying for the bailouts with tax dollars).
• The council was allowed to break up banks considered too large and could also force them to increase their reserve requirements.
• The act required more transparency and standardization of derivatives transactions.
• The act created a new agency (the Consumer Financial Protection Bureau) whose job was to prevent predatory mortgage lending and make it easier for consumers to understand the terms of a mortgage before agreeing to them.
• The act established the SEC Office of Credit Ratings, which was in charge of making sure that rating agencies provided reliable credit ratings.
• The act strengthened and expanded the existing whistleblower program.

You can read more about the Dodd-Frank Act here.

Although there were a number of vital reforms made, you’ve undoubtedly noticed that they mostly focused on the banking industry, leaving the shadow banking sector (which we learned about in a previous post) largely intact. So to this day, the shadow economy remains largely unregulated. That, of course, is problematic, because we have no transparency into what is happening in the shadow banking economy. This is one of the biggest benefits of crypto — nothing that happens in crypto can remains in the shadows because it is all open-source and transparent.

Communication about monetary policy

The level of communication that the Fed has with the public about monetary policy was determined to be lacking, and this lack was judged to be one of the factors behind various financial crises. The Fed is now expected to communicate more clearly about when it expects to adjust the federal funds rate. This will allow investors to better understand policy goals and anticipate future policy actions.

For example, the chairman of the Fed began holding news conferences in 2011. In fact, the Federal Reserve now even has a YouTube channel where updates are posted periodically.

The Fed has also recently begun to provide more information about its goals and policy approach (for example, defining price stability as inflation of 2% in the medium-term).

Conclusion

Wow! You made it this far through the history of money. Congratulations. Assumed you’ve gone through the previous articles in this series, you now have a rock-solid understanding of how the central banking system in the US started, and how it evolved over time through various booms and busts. Moreover, you learned about how effective (or ineffective) the Federal Reserve was in keeping the financial system afloat if/when there was a bust.

Financial crises will always be with us. However, the goal remains to minimize the intensity of these crises and avoid major damage to the economy. Since we cannot predict or eliminate shocks to the economy, we must build a system that can resist these shocks without collapsing.

I want you to start thinking about whether the new financial system we are building with Bitcoin and other cryptocurrencies is more (or less) resilient than the system we have now, with the Federal Reserve and other central banks around the world serving as the central coordinators of monetary policy.

Before we move on to learning about the cypherpunks and early precursors to Bitcoin, we have one final lesson where we will look at a series of charts that paint a shocking picture of our financial system after Nixon moved the United States off the gold standard in 1971. Stay tuned. 😊