Banks Gone Wild

Notwithstanding economic growth in the 1990s and steadily increasing productivity, wages had remained largely flat relative to inflation since the end of the 1970s; despite the mild recovery, they remained so. To compensate, many consumers were buying on credit, and with interest rates low, financial institutions were eager to oblige them. By 2008, credit card debt had risen to over $1 trillion. More importantly, banks were making high-risk, high-interest mortgage loans called subprime mortgages to consumers who often misunderstood their complex terms and lacked the ability to make the required payments.

Incentives to Make Bad Loans

These subprime loans had a devastating impact on the larger economy. In the past, a prospective home buyer went to a local bank for a mortgage loan. Because the bank expected to make a profit in the form of interest charged on the loan, it carefully vetted buyers for their ability to repay. Changes in finance and banking laws in the 1990s and early 2000s, however, allowed lending institutions to securitize their mortgage loans and sell them as bonds, thus separating the financial interests of the lender from the ability of the borrower to repay, and making highly risky loans more attractive to lenders. In other words, banks could afford to make bad loans, because they could sell them and not suffer the financial consequences when borrowers failed to repay.

Once they had purchased the loans, larger investment banks bundled them into huge packages known as collateralized debt obligations (CDOs) and sold them to investors around the world. Even though CDOs consisted of subprime mortgages, credit card debt, and other risky investments, credit ratings agencies had a financial incentive to rate them as very safe. Making matters worse, financial institutions created instruments called credit default swaps, which were essentially a form of insurance on investments. If the investment lost money, the investors would be compensated. This system, sometimes referred to as the securitization food chain, greatly swelled the housing loan market, especially the market for subprime mortgages, because these loans carried higher interest rates. The result was a housing bubble, in which the value of homes rose year after year based on the ease with which people now could buy them.

Banks Gone Broke

Mortgages had been so heavily leveraged that when American homeowners began to default on their loans, the whole system collapsed. More than one hundred mortgage lenders went out of business. American International Group (AIG), a multinational insurance company that had insured many of the investments, faced collapse. Other large financial institutions, which had once been prevented by federal regulations from engaging in risky investment practices, found themselves in danger, as they either were besieged by demands for payment or found their demands on their own insurers unmet. The prestigious investment firm Lehman Brothers was completely wiped out in September 2008. Some endangered companies, like Wall Street giant Merrill Lynch, sold themselves to other financial institutions to survive. A financial panic ensued that revealed other fraudulent schemes built on CDOs. The biggest among them was a pyramid scheme organized by the New York financier Bernard Madoff, who had defrauded his investors by at least $18 billion.

The Wall Street Bailout

Figure 1. Treasury Secretary Henry Paulson, Federal Reserve Ben Bernanke, chairman of the SEC Christopher Cox, and James B. Lockhart III testifying to the Senate Banking Committee.

Realizing that the failure of major financial institutions could result in the collapse of the entire U.S. economy, the chairman of the Federal Reserve, Ben Bernanke, authorized a bailout of the Wall Street firm Bear Stearns, although months later, the financial services firm Lehman Brothers was allowed to file for the largest bankruptcy in the nation’s history. Members of Congress met with Bernanke and Secretary of the Treasury Henry Paulson in September 2008, to find a way to head off the crisis. They agreed to use $700 billion in federal funds to bail out the troubled institutions, and Congress subsequently passed the Emergency Economic Stabilization Act, creating the Troubled Asset Relief Program (TARP). One important element of this program was aid to the auto industry: The Bush administration responded to their appeal with an emergency loan of $17.4 billion—to be executed by his successor after the November election—to stave off the industry’s collapse.

The actions of the Federal Reserve, Congress, and the president prevented the complete disintegration of the nation’s financial sector and warded off a scenario like that of the Great Depression. However, the bailouts could not prevent a severe recession in the U.S. and world economy. As people lost faith in the economy, stock prices fell by 45 percent. Unable to receive credit from now-wary banks, smaller businesses found that they could not pay suppliers or employees. With houses at record prices and growing economic uncertainty, people stopped buying new homes. As the value of homes decreased, owners were unable to borrow against them to pay off other obligations, such as credit card debt or car loans. More importantly, millions of homeowners who had expected to sell their houses at a profit and pay off their adjustable-rate mortgages were now stuck in houses with values shrinking below their purchasing price and forced to make mortgage payments they could no longer afford.

The Impact of the Great Recession

Without access to credit, consumer spending declined. Some European nations had suffered similar speculation bubbles in housing, but all had bought into the mortgage securities market and suffered the losses of assets, jobs, and demand as a result. International trade slowed, hurting many American businesses. As the Great Recession of 2008 deepened, the situation of ordinary citizens became worse. During the last four months of 2008, one million American workers lost their jobs, and during 2009, another three million found themselves out of work. Under such circumstances, many resented the expensive federal bailout of banks and investment firms. It seemed as if the wealthiest were being rescued by the taxpayer from the consequences of their imprudent and even corrupt practices.

Income and Wealth Inequalities Magnified

The Great Recession only magnified already rising income and wealth inequalities. According to the chief investment officer at JPMorgan Chase, the largest bank in the United States, “profit margins have reached levels not seen in decades,” and “reductions in wages and benefits explain the majority of the net improvement.”^[1] A study from the Congressional Budget Office (CBO) found that since the late 1970s, after-tax benefits of the wealthiest 1 percent grew by over 300 percent. The “average” American’s after-tax benefits had grown 35 percent. Economic trends have disproportionately and objectively benefited the wealthiest Americans. Still, despite political rhetoric, American frustration failed to generate anything like the social unrest of the early twentieth century. A weakened labor movement and a strong conservative bloc continue to stymie serious attempts at reversing or even slowing economic inequalities.

Occupy Wall Street managed to generate a fair number of headlines and shift public discussion away from budget cuts and toward inequality, but its membership amounted to only a fraction of the far more influential and money-driven Tea Party. Its presence on the public stage was fleeting.

Figure 2. Protestors as a part of the Occupy Wall Street movement.

The Great Recession, however, was not. While American banks quickly recovered and recaptured their steady profits, and the American stock market climbed again to new heights, American workers continued to lag. Job growth was slow and unemployment rates would remain stubbornly high for years. Wages froze, meanwhile, and well-paying full-time jobs that were lost were too often replaced by low-paying, part-time work. A generation of workers coming of age within the crisis, moreover, had been savaged by the economic collapse. Unemployment among young Americans hovered for years at rates nearly double the national average.