From the December 2008 issue of Research Magazine • Subscribe!

The Crisis in a Nutshell

The current financial crisis began when the American Dream of home ownership was planted in the hearts of millions, even those that didn't have the fiscal discipline or financial wherewithal to be homeowners.

To combat the economic aftermath of 9/11, the Federal Reserve lowered interest rates. Greenspan & Company badly miscalculated by keeping rates too low for too long.

Home prices rose anyway, reinforcing the American dream.

Artificially low interest rates created cheap mortgages which created a speculative boom in real estate.

Aggressive mortgage brokers capitalized by selling doomed subprime mortgages to unqualified borrowers. Despite a fundamental breakdown of lending standards and regulatory oversight, no one noticed. Banks and brokers collected billions.

Home prices continued to soar. From 2002 to 2007, the S&P/Case-Shiller Home Price Index of 20 metropolitan cities outpaced the stock market and jumped by 75 percent. Inflated real estate lured consumers, homebuilders and investors into a false sense of financial security.

Consumers continued to binge on real estate and home equity lines.

Instead of holding mortgages and collecting the interest on the yield from the loans, lenders pooled them into securitized burritos. The packaged loans were sold with the help of inflated ratings from Standard & Poor's and Moody's.

Wall Street's underwriters collected billions in fees and rating agencies got their cut. Earnings and profits rose, but executive compensation rose faster.

Investment banks like Bear Stearns and Lehman Brothers devolved into highly leveraged hedge fund-like entities. Both firms collapsed.

Mutual funds, hedge funds and other financial institutions that overdosed on risky mortgage securities that were once deemed safe began to falter.

Ailing mortgage borrowers set off a tsunami of defaults, which triggered a collapse in the value of mortgage-backed securities. Financial institutions were forced to write down more than $1 trillion from their balance sheets.

Other opaque financial instruments like auction rate securities and credit default swaps blew up.

Home foreclosures accelerated, which created a glut of residential real estate pushing home prices down further.

Financial giants like AIG, Freddie Mac, Fannie Mae, IndyMac, Lehman Brothers and Washington Mutual collapsed. Others followed.

The financial chaos even took its toll on "safe" investments. The $62 billion Reserve Primary Fund, one of the first money market mutual funds, was forced to liquidate.

Consumers panicked by withdrawing money from their banks and mutual funds.

FDIC increased its coverage of bank deposits to $250,000 per customer from $100,000 through 2009.

Home prices crumbled even further.

Financial stocks within the S&P 500 fell by 45 percent.

The meltdown demolished America's retirement plans by some $2 trillion.

Banks and financial institutions fought for survival by hoarding cash. They stopped lending to their clients and to each other.

Without cash flowing from banks, businesses couldn't carry on their daily operations, much less grow.

Liquidity in the financial system dried up.

Congress passed into law a $700 billion rescue package to help the U.S. financial industry.

The stock market fell and the future prospects of earnings and GDP growth dimmed.

And here we are.

---

Ron DeLegge is the San Diego-based editor of www.etfguide.com.

Reprints Discuss this story
This is where the comments go.