Presidential Election 2008:
FINANCIAL CRISIS

By Alan Shapiro

To the Teacher

The nation has been transfixed by a rapidly developing financial crisis whose full consequences for major financial institutions, ordinary Americans, people abroad, and the presidential candidates remain to be seen. The crisis has very complicated elements, so complicated that corporate CEOs probably could not explain them clearly.

The two student readings below aim to clarify some aspects of the developing crisis, what federal officials are doing about it, and how the presidential candidates view it. Discussion questions and other activities follow.

Teachers may also find useful the following materials on issues related to the financial situation available in the high school section of www.teachablemoment.org:
"Presidential Election 2008: Inequality in America" and "Economic Anxiety" deal with economic issues, "Big Problems at 3 Federal Agencies" with regulatory matters.

Student Reading 1:
Rise and fall of bubbles

For ordinary Americans, the signs of a financial crisis were everywhere:

• More and more people losing their jobs
• Food prices high and rising
  
• Foreclosure signs in front of empty houses
  
• Credit card debt ballooning
  
• Loans at the once friendly bank becoming hard to get
  
• Less college grant money available
  
• Gas prices near $4 a gallon
  
• The stock market gyrating wildly
  
• Confidence in America's financial system eroding
  
• Government officials taking unprecedented steps to bail out private companies

Two bubbles

Bubble: a balloon-like object filled with hot air. In the financial world, a bubble refers to a speculative mania fueled by ballooning profits on certain investments. What those investors fail to notice is that a hot air fever encourages them to believe they are acting on a sure thing up to the very moment the balloon is ready to burst.

The first of two related bubbles began in the mid 1990s with a speculative fever over new internet companies. This became known as the dot-com bubble. Investments in dot-coms soared. The bubble lasted a half dozen years before dot-com companies began collapsing, bursting the bubble and taking tech and other stocks down with it.

To shore up the economy, the Federal Reserve lowered interest rates for the next two years from 6.5 percent to 1 percent. This made credit easy to get and helped to fuel the second bubble. "Once stocks fell [after the dot-com bubble burst], real estate became the primary outlet for the speculative frenzy that the stock market had unleashed," Yale economist Robert Shiller wrote in 2005. "Where else could plungers apply their newly acquired trading talents….These days the only thing that comes close to real estate as a national obsession is poker." (www.en.wikipedia.org/wiki/Dot-com_bubble) Shiller wrote these words at a time when many deluded American homeowners believed the values of their homes would continue rising forever.

Today, a second bubble has burst. The following events were major factors in producing today's financial crisis.

1. Low interest rates that made it easy to get credit fueled a demand for houses, especially among Americans who had never had one.

2. Banks and mortgage broker companies loaned money to many people who wanted to buy a house but could not make a down payment, whose credit history was poor, and who were not required to provide proof of their financial condition.

3. Such people could only afford "sub-prime," adjustable rate mortgages (ARMs). Typically, these mortgages required homebuyers to pay a low fixed-rate payment for two years-and the adjustable rate would kick in, requiring rising payments. Some buyers did not understand that this would happen, and some sellers misrepresented the situation.

4. Banks and brokers struck gold. They packaged and sold collections of these mortgages to investment houses, which sold them to companies around the world, which sold them to investors.

5. The flood of sub-prime homebuyers helped to drive up home prices.

6. The results delighted everyone. Hundreds of thousands of new homeowners believed that if they could not make rising payments two years down the road, they would simply borrow money on their rising home value or sell their houses for more than they paid for them. Millions of established homeowners were able to get home equity loans on the increasing value of their property and do whatever they desired with the money. Brokers, banks, investment houses and individual investors found that their pockets were overflowing.

7. Everything that goes up must come down, which is what began to happen in 2006. The housing market was saturated. Home prices fell and fell some more.

8. Unable to make rising payments on their sub-prime loans and unable to borrow on the reduced value of their home or to sell it, new homeowners faced foreclosure. Falling real estate prices also meant trouble for many established homeowners. The cash value of their homes falling, they were unable to sell them for prices they had expected to get. Some people who did sell their homes ended up still owing money on their original mortgage. Banks, brokers and investment houses could no longer sell their mortgage packages and were left holding paper that was rapidly sinking in value. Investors were left with mortgage securities worth little.

9. Losses rose everywhere. Investment bankers could not raise more money. Banks cut back on loans. Loans became difficult to come by even for those with good credit histories. A vicious cycle was underway.

10. Suddenly, like dominos, leading global investment banks and wealth management firms fell: Bear Stearns, Lehman Brothers and Merrill Lynch. The government took over Fannie Mae and Freddie Mac, two publicly traded stockholder-owned institutions created by the U.S. government that hold more than half the mortgages in the country. Then the U.S. Federal Reserve loaned money to rescue the American International Group (AIG), an huge global insurance company, in exchange for equity in the company.

11. The stock market headed for a cliff, taking millions of investors with it.

12. Uncertainty about what would happen next brought on high anxiety and fear to U.S. and global financial markets and ordinary Americans.

For discussion

1. What questions do students have about the reading? How might they be answered?

2. What evidence of the financial crisis have students noticed and/or experienced?

3. Why is the term "housing bubble" often cited as a major cause of the crisis?

4. What fueled the housing bubble? Why were investors making so much money?

5. What caused the bubble to burst? With what results?

Student Reading 2:
Officials & candidates respond to the crisis

As the financial crisis deepened, federal officials believed they had no alternative but to violate a fundamental principle of American capitalism-that taxpayer money should not be used to bail out private companies. U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, with President Bush's support, proceeded to do just that.

For example, they and other federal officials decided they could not permit the collapse of Fannie Mae and Freddie Mac. That would cause terrible damage to the home mortgage business in America, since the two companies hold more than half the country's mortgages. The federal government bailed them out with an injection of $200 billion in taxpayer money.

Nor could they permit AIG to fail. That would devastate people who were insured by the company here and around the world, which would have drastic international repercussions. When the Federal Reserve stopped the bleeding of Fannie Mae and Freddie Mac and then, with an additional $85 billion of taxpayer money, the bleeding of AIG, the U.S. government was, in effect, nationalizing private companies just as a socialist government might. Officials said the domestic and international consequences of their failure would be horrendous. These companies "are too big to be allowed to fail," officials said.

But the U.S. financial system continued its free fall. Secretary Paulson and Chairman Bernanke began holding discussions with Congressional leaders on a complex plan aimed at using federal dollars to buy failed mortgage-backed securities from endangered banks and other financial institutions. The cost would be $700 billion of taxpayer money--on top of the money taxpayers will have to shell out for bailouts of the two Macs and AIG. But what the final bill would be no one knew for sure--perhaps a trillion dollars or more, or perhaps less. If the market calms down and house prices rise, the mortgage-backed securities the government bought at fire sale prices might turn out to be saleable and produce a profit.

The government buyout was essential, Secretary Paulson said, because "irresponsible borrowing and lending" and an "outdated" government regulatory system had caused credit to freeze up-meaning that people could no longer get loans to buy homes or cars or to finance their businesses. Unfreezing these funds was essential to getting the economy going again. The alternative was far worse, the Secretary concluded. President Bush said that "government intervention is not only warranted, it is essential."

Critics were quick to point out that President Bush and other officials had maintained that the financial markets could regulate themselves. The financial crisis proved them wrong.
How much regulation did these markets need to prevent another crisis like the one now gripping the country? How much would be too much and stifle innovation?

After the buyout plan was released on September 20, Democrats immediately insisted that any final plan should include help for hundreds of thousands homeowners faced with foreclosure and jobless Americans whose problems were brought on by an "outdated regulatory system." Democrats also called for limits on the multi-million dollar pay packages of top executives at firms seeking aid. Since Secretary Paulson would have great new power to administer the plan, legislators and presidential candidates Obama and McCain agreed that more oversight needed to be built into it. In addition, financial firms were lobbying for an even larger bailout to include other shaky investments, not just mortgages.

Congress was scheduled to adjourn by the end of the week of September 21 so that legislators running for reelection can go home to campaign. The pressure was on to approve a plan whose costs were astronomical, probably exceeding those that Congress has ever approved on a single program.

Responses from McCain and Obama

The economy was already the top issue in the presidential campaign. As the financial crisis unfolded, it became an even more critical, perhaps a decisive, issue. Senator John McCain said repeatedly and as recently as September 15 in Jacksonville, " I think still, the fundamentals of our economy are strong." When he was criticized for this view, he said he had been referring to the fundamental soundness of American workers. The economy faced a critical situation "because of the greed by some based in Wall Street and we have got to fix it." Like other Republicans, he has long supported deregulation and allowing market forces to make corrections when needed without federal meddling.

After Republicans gained control of Congress in 1995, McCain said excessive regulations were "destroying the American family" and called for a moratorium on many of them. Recently he told the Wall Street Journal that he supported oversight in crises like the mortgage situation, "but I am fundamentally a deregulator."

Senator Obama said, "I certainly don't fault Senator McCain for these [financial] problems, but I do fault the economic philosophy he subscribes to." Obama called for regulation of investment banks and mortgage brokers and a commission to monitor the financial system and report its findings to Congress and the president.

Obama had warned about a housing crisis in March 2007. More recently he said the nation was facing "the most serious financial crisis since the Great Depression." He blamed the Bush administration for deregulatory policies that he said Senator McCain would only continue. Obama said that any plan had to work "not just for Wall Street, but for Main Street."

According to the nonpartisan Center for Responsive Politics, which provides detailed reports on campaign contributions, both candidates have received millions for their campaigns from Wall Street. Senator Obama has received $9.9 million from individuals involved in the securities and investment industry. Senator McCain has received $6 million.

For discussion

1. What questions do students have about the reading? How might they be answered?

2. What is the basic government plan to end the financial crisis? What do Democrats want to add to it and why?

3. How did Secretary Paulson define the problem?

4. What have been the reactions of the two presidential candidates to the crisis?

For continuing study

To follow up on discussions of these readings, students might be assigned specific questions and report on answers to the class. For example:

1. Explain the financial plan the U.S. Treasury Secretary and Fed Chairman Bernanke have proposed.

2. What criticisms of the plan have been made by legislators? By members of public organizations and media such as the conservative American Enterprise Institute (www.aei.org) and National Review (www.nationalreview.com)? The liberal Center for American Progress (www.americanprogress.org) and The Nation (www.thenation.com)?

3. How has each presidential candidate responded to the crisis?

4. What is the response of Wall Street?

5. What other related financial developments are taking place?

For inquiry

The bubbles that led to the current financial crisis are not by any means the first in history. Tulip mania, of all things, struck Holland in the 17th century, leading to a frenzied market in tulips and a bubble whose collapse resulted in ruin for Dutch investors in 1637.

The British granted the South Sea Company a monopoly of trade with Latin America that inspired wild speculation, leading to the South Sea Bubble and financial disaster of 1721.
Thousands of American businesses went under after the collapse of a major bank that led to the Panic of 1873. Stock market speculation led to the Crash of 1929 and a Great Depression that lasted until World War II.

Organize independent and small group investigations on any of these bubbles based on clearly-stated questions to guide inquiry.

We welcome your comments and would love to hear your experiences using this activity in your classroom. Please email author Alan Shapiro at: ashapiro7@comcast.net.

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