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Cheri Wegwitz
Jolynne Berrett
Engl 1010
11/25/2012
Stock Market Crash of 2008
The Stock Market Crash of 2008 was devastating for citizens of the United States of
America. Not only were 10’s of trillions of dollars lost, but eight million people lost their jobs.
Over one million families had their homes foreclosed upon with another 1.87 million homes having received a foreclosure filing. These aren’t the only marks the stock market crash has made in our economy. Just under 25% of homeowners owe more on their homes than they’re worth. (Michael, 2011) So, our assets are down and yet our consumer goods keep increasing. A few goods that seem to affect Americans the most are the rising gas prices, higher power bills and rising prices of groceries. Rising costs are on track to cause more devastation, all due to the
Stock Market Crash of 2008. All of these things are a factor in why Americans have named our economy as “slow.”
Due to the slow economy we’re currently experiencing it’s important to understand what caused the stock market crash of 2008. We need to learn about the factors which led up to this event in order to look for warning signs of it happening again in the future. There’s an old adage by George Santayana that has been often repeated. “Those who cannot remember the past are condemned to repeat it.” Have we done just that? Analysts have cited many different reasons for

C Wegwitz 2 the actual crash. However, as America has had a major stock market crash prior in our history, it begs the question as to whether or not the stock market crash of 2008 could have been prevented, just from knowing and heeding the warning signs. In this paper we will discover what set the stage for the crash, what experts cite their belief to be the actual reason of the stock market crash, if there is any correlation to the stock market crash of 1929 and whether or not the recession could have been circumvented.
Though all experts agree and cite the original problem of the stock market crash of 2008 to be due to the creation of subprime mortgages, from there they have different views. Experts vary as to whether or not it is Fannie Mae’s fault or the fault of the government from changing its laws, or governments fault for spotting warning signs and not doing anything to correct the situation or even whether it’s America’s fault due to acting irrationally on their fears. Before we dive into their views, we should know what events led up to the creation of these subprime mortgages. In 1995, the Clinton Administration changed the law regarding the CRA, or
Community Reinvestment Act. This act was created with the best of intentions. It was designed to encourage lending to low-income families in poorer neighborhoods as government felt these families were not being lent to fairly. This Act helped many Americans achieve their American
Dream of homeownership, where typically they wouldn’t have been able to. Due to changes made to this act, banks were monitored based on their lending activity and even gave ratings based on how many home loans they gave to low income areas. Fannie Mae, or FNMA, was created by the government as a secondary market for home mortgages. FNMA was created to aide banks when banks needed to sell a mortgage, due to needing to maintain a certain ratio of

C Wegwitz 3 debt to capital. Typically, this is 3:1. If banks debt to capital ratio becomes off-balance, they generally sell off some of their debt, i.e. home loans. After changes to the CRA, FNMA started to require banks fulfill a certain quota of mortgages they granted to lower incomes and minorities. Due to banks wanting to receive higher ratings, as well as a pressure to please
FNMA, (as FNMA were banks’ back-up in purchasing their excess home loans when their debt to capital ratio was off-balance) banks began to reduce standards on approving mortgage loans as well as began to create creative financing options for consumers. It was here where people began to receive approval for their loans with low down payments and/or low incomes. These were called sub-prime mortgages. Banks felt safe granting sub-prime mortgages as they had FNMA in the background ready to buy any mortgages the banks wanted to sell to them, even if these loans weren’t properly documented and/or extremely risky. FNMA has been cited by Thayer Watkins, a professor at San Jose State University, as poorly “pursuing social welfare goals rather than maintaining financial viability. (Watkins, 2009) Lenders were strongly encouraged to reduce the requirements for mortgage below what had been found to be the minimum adequate levels. It is this reason that Watkins places the blame of the stock market crash of 2008 on FNMA.
Lawrence H. White also places the blame on FNMA and has said this. “The Department of
Housing and Urban Development budget costs taxpayers more than $50 billion annually, but the economic damage caused by ill-advised federal housing policies has cost the U.S. economy far more than that.” (White, 2009)
While the CommonSenseEconomics.com group, consisting of James Gwartney, David
Macpherson, Russell Sobel and Richard Stroup, believe FNMA has a big part in the stock market

C Wegwitz 4 crash, they have other insights. They believe the stock market crash of 2008 is ultimately the fault of the government for four main reasons. They started by giving their own background to what was happening in the United States at this time. They say the economy was strong with low unemployment rates. This led to high confidence in the economy as well as housing market. At this time, house prices were solid and due to extremely low interest rates set up by the Federal
Reserve, mortgage-only loans and ARM’s, or adjustable rate mortgages, were very appealing. So as house prices began to rise, more and more investors were choosing real estate as a safe venture as to this point, it had been. At this point, typical debt ratios as well as other safe lending practices were being ignored. Many Americans were able to purchase homes way over debt ratios that were considered safe and lent to, with little to no down payments. This resulted in greater than 90% loan-to-value ratios. This was done due to banks increasing their debt/capital ratio of investments. Before this time, banks were required to maintain a 3:1 ratio of debt to capital. This was increased in many cases to as high as 40:1. These increases were allowed as investments banks still considered home loans to be safe as America had been maintaining a low default rate. It was due to the low default rate that security rating firms deemed even risky loans as low risk. These security rating firms would assign AAA ratings to even the most risky loans.
(James Gwartney, 2009) Tom DeGrace of the StockPicksSystem investment services said this,
“With each loan, banks would quickly securitize the loan and pass the risk off to someone else.
Ratings agencies put AAA ratings on these loans that made them highly desirable to foreign investors and pension funds .
” (DeGrace, 2011) It was factors like this that set up conditions ripe for disaster. All of these factors led to a rise in home values which seemed to benefit everyone.
During the years 2005-2007, 97% of all new loans were interest only loans which had been

C Wegwitz 5 agreed to by homeowners who felt confident interest rates would continue to stay low. Others who agreed to these types of loans were investors who felt they could sell their purchase after a few months and make a profit from the ever increasing home values. When interest rates went up, it caused many people who relied on the lower interest rates, to lose their homes. This resulted in a decrease of home values which then affected investors. So, it was these four factors:
1. A change in looser lending standards. 2. Prolonged lower interest rates. 3. Increased
Debt/Capital Ratio of Investment Banks. 4. High debt/income ratio of households which were the reasons cited by the CommonSenseEconomics group as to why the government was responsible for the stock market crash. (James Gwartney, 2009)
While Kimberly Amadeo, who writes for About.com, blames the government as well, she has different reasons. She cites the government as having seen problems early in “2007 and ignored all warning signs as they didn’t think the housing slowdown would have any effect on the economy.” (Amadeo, 2012) She goes on to say that finally at the end of 2007, they did recognize the problems banks were having and tried to step in but still ignored the other problems associated with the downfall of the stock market and economy. Could Kimberly
Amadeo be right? Were there warning signs pointing to a stock market and economy crash? For purposes of answering this question, research was done as to what signs there were prior to the first stock market crash of 1929. Tejvan Pettinger wrote an article for economicshelp.org on just this question. Pettinger explains it well by saying,
In the 1920s, there was a rapid growth in bank credit and loans. Encouraged by the strength of the economy people felt the stock market was a one way bet. Some

C Wegwitz 6 consumers borrowed to buy shares. Firms took out more loans for expansion. Because people became highly indebted, it meant they became more susceptible to a change in confidence. When that change of confidence came in 1929, those who had borrowed were particularly exposed and joined the rush to sell shares and try and redeem their debts. (Pettinger, 2012)
Pettinger goes on to explain what buying on the margin means when concerning the stock market. Pettinger explains it as investors paying only a small amount of the value up front
(typically 10-20%) They would then borrow the other 80-90% of the shares value. Thus, investors were able to buy more stocks than they would normally be able to as their money would be freed up. As more shares are bought, the value of the shares rose. In fact, at this time in history, this was very popular to do. This system created many investors who were called
‘margin millionaires. They were named margin millionaires as they bought on the margin and became wealthy doing so. However, these same investors were the ones who were hit the hardest when prices fell. Those next greatly affected were the banks and investors who had lent money to those who were “buying on the margin.” (Pettinger, 2012) Pettinger blames the Stock Market crash of 1929 on “over-exuberance and false expectations.” Before 1929, the stock market was a great opportunity for those wanting to make large amounts of money and has been likened to a gold rush as consumers bought shares with the expectation of making money. In fact, as prices of shares kept rising, more and more consumers wanted to make money from the system and even started to borrow money, just to be able to invest in the stock market. It was considered to be a safe investment (like houses were to those in the 2000’s) as it had been safe up to this point. This is why it was so devastating to those who borrowed to invest in the stock market. However, share prices continued to rise and so the market “got caught up in a speculative bubble.- Shares kept

C Wegwitz 7 rising and people felt they would continue to do so. The problem was that stock prices became divorced from the real potential earnings of the share prices.” Prices became driven from peoples’ optimism and the exuberance of investors and not from typical “economic fundamentals.” (Pettinger, 2012) In fact, according to Pettinger, the average share rose by 400% in the years from 1923-1929.
While reading this quote, many correlations jumped out to me from what happened in
1929 to what happened in 2008. Investors were encouraged, or confident by the strength of the economy. Consumers borrowed high amounts to invest in the “safe bet.” Consumers were
“buying on the margin” putting very little down on their investments. Banks and investors in both cases were greatly affected from lending money for investments. There were many margin millionaire investors with real estate like the stock market in having a huge potential of making large amounts of money by investing. People were optimistic and exuberant in their investing and the things they invested in were caught up in a “bubble.” Also, although house prices didn’t rise by 400%, they did double or triple in many areas of the country, seemingly overnight. In the
1900’s Americans switched from investing in the gold rush bust to stock market and in the
2000’s American’s switched from investing in the internet after the dot.com bust to investing in real estate. Both times, this resulted in a “bubble” in the new investing area they switched to. If there were this many correlations from The Stock Market Crash of 1929 to The Stock Market
Crash of 2008, how come the government didn’t recognize the devastating potential after seeing warning signs, as Kimberly Amadeo suggests? In the next part of this essay, you’ll see the

C Wegwitz 8 correlation between those who have huge debts in investments strongly relying on their confidence in the economy for success.
The last aspect of the stock market crash being pursued is an idea written for the Journal of Economic Dynamics & Control by Roger Farmer. In this article, he asserts the crash was due to a shift of beliefs. Homeowners and consumers once confident in the economy had replaced that confidence with fear. This made the “economy shift from dynamic equilibrium where house prices grew explosively to a steady state equilibrium where house prices lowered and unemployment raised.” (Farmer, 2012) According to Farmer, this resulted in a fall in values of real estate which “then triggered a secondary collapse in financial assets whose value was collateralized by real estate wealth.” (Farmer, 2012) Once there was a collapse in real estate wealth, this trickled down to an initial stock market crash which then triggered a permanent drop in incomes of households. This resulted in less economic spending and more money being stockpiled into savings as consumers were unsure as to their future stability. Once there was a reduction of demand, businesses then were forced to do layoffs. “Layoffs triggered a drop in business income which validated the initial drop in confidence. Thus the 2008 financial crisis was a self-fulfilling prophecy.” (Farmer, 2012) He asserts the United States didn’t officially enter into a recession until after the stock market decline and that was due to the fears and lack of confidence by the people/investors. Once confidence was down, the result was an overall panic, just like the people who experienced the stock market crash of 1929. Adam Shell who writes for
USA Today also contributes The Stock Market Crash of 2008 to consumer fear and said this.
“The Dow plunged 2,675 points after investors fearing a financial collapse went on a panic-

C Wegwitz 9 driven stock-selling spree that resulted in five of the 10 biggest daily point drops in the iconic
Dow's 123-year history.” (Shell, 2012)
As you can see, there were many contributing factors as to what caused the stock market crash of 2008. I believe it’s a compilation of all these beliefs. From the experts cited we see a logical course leading from FNMA being created which then led to the government loosening their lending laws. This led to signs of trouble which the Government ignored which led to
Americans having fears and acting on them. All of this resulted in the Stock Market Crash of
2008. In this sequence, the most upsetting of all is how our government who we trust to protect us, spotted signs of trouble and ignored it. There are too many obvious and overwhelming similarities between The Stock Market Crash of 1929 to our recent Stock Market Crash of 2008 to believe they didn’t spot signs of trouble. This means that our government had to have ignored the warning signs leading up to our recent stock market crash. If this theory is true, they let the
American people down. If our government had only started trying to reverse the situation at the first onset of warning signs, Americans might have remained confident in the economy. If
Americans remained confident, home values might have remained stable which may have had a lesser negative effect on the economy. At this point, the best thing to do is to remain optimistic that our economy will stabilize and invest in local businesses, so once again America’s economy can become strong. Above all, we need to learn from these events this time, as obviously we didn’t remember the past and were condemned to repeat it.

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Amadeo, K. (2012, June 9). Stock Market Crash of 2008. Retrieved December 10, 2012, from About.com: http://useconomy.about.com/od/Financial-Crisis/a/Stock-Market-Crash-2008.htm
DeGrace, T. (2011, December 18). THE HOUSING MARKET CRASH OF 2007 AND WHAT CAUSED THE
CRASH. Retrieved December 10, 2012, from StockPicksSystem Investment Services: http://www.stockpickssystem.com/housing-market-crash-2007/
Farmer, R. E. (2012). The stock market crash of 2008 caused the Great Recession:. Retrieved December
10, 2012, from Journal of Economic Dynamics & Control: http://www.rogerfarmer.com/NewWeb/PdfFiles/farmer_final_jedc_r.pdf
James Gwartney, D. M. (2009). Stock Market Crash of 2008. Retrieved December 10, 2012, from
Common Sense Economics: http://www.commonsenseeconomics.com/Activities/Crisis/CSE.CrashOf2008.pdf
Michael. (2011, March 19). 27 Amazing Statistics About The Real Estate Crash That Never Seems To End:
More Foreclosures, More Underwater Mortgages And More Home Price Declines. Retrieved December
10, 2012, from The American Dream: http://endoftheamericandream.com/archives/27-amazingstatistics-about-the-real-estate-crash-that-never-seems-to-end-more-foreclosures-more-underwatermortgages-and-more-home-price-declines
Pettinger, T. (2012, November 5). What Caused the Stock Market Crash of 1929? Retrieved December
10, 2012, from Economics Help: http://www.economicshelp.org/blog/76/economics/wall-street-crash-
1929/
Shell, A. (2012, October 2). It's October: Is the stock market crash-proof. Retrieved December 10, 2012, from USA Today: http://www.usatoday.com/story/money/markets/2012/10/02/october-stock-marketcrash-proof/1601355/
Watkins, T. (2009). The Nature and the Origin. Retrieved December 10, 2012, from San José State
University Department of Economics: http://www.sjsu.edu/faculty/watkins/subprime.htm
White, T. H. (2009, August). Housing Finance and the 2008 Financial Crisis. Retrieved December 10,
2012, from Downsizing the Federal Government: http://www.downsizinggovernment.org/hud/housingfinance-2008-financial-crisis

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