Understanding the economic crisis

A helpful and easy guide for students

By Kaitlin Strohschein
If the Dow Jones Industrial Average dropped by 777 points (as it did on September 29, 2008) for 14 days in a row, there would be no Dow Jones left.
Although statistically there have been a couple of points in American history when citizens have been more afraid about the stock market than they are currently, Grace Kim, a professor of Economics at BCC said, “This is a crisis on a scale that I haven’t seen in my lifetime, and while I am often amazed at the resiliency of markets, I’m waiting to see what happens.”Understanding the characters in the current American economic “drama” may help Americans write an appropriate ending.
The Dow Jones Industrial Average, which has long been considered an important indicator of the American economy’s health, is a compilation of the stocks of the 30 companies that are considered to be, financially, the “best” in their respective areas of business. The Dow is often used as a shortcut to see the general performance of the American stock market.
Cash is the lifeblood of Dow companies. They raise cash in three main ways: by issuing stocks and bonds, by selling their assets (or physical “stuff”), and by taking out loans from banks. Therefore, when a lot of people decide that they don’t want a company’s stocks or bonds, that corporation is forced to rely more heavily on loans. The relationship between banking and the stock market is so close that when the banking industry catches a cold, the stock market gets sick.
During the stock market crash of 1929, about 20 percent of U.S. banks failed. These banks went under largely because they mixed their risky lending with their safer loans. Four years after the stock market crash, Senator Carter Glass and Congressman Henry Steagall wrote a bill to more cleanly divide safe and risky investments to prevent future “great depressions.” In 1999, the Gramm-Leach-Bliley Act, also known as Financial Services Modernization Act, struck down several of the limitations set by the Glass-Steagal Act of the 1930s.
The Bliley Act, which was a landslide, bi-partisan victory of 90 yea to 8 nay, is now being blamed by many for the current banking crisis. Although politicians are currently trying to distance themselves from the Bliley Act, on November 4, 1999, in his Majority Leader’s Statement, Trent Lott said that the act would “allow us [the United States] to be more equally competitive around the world.”
Some claim that, although it is convenient to blame the current economic mess on massive, recent banking deregulation, such an accusation is not entirely fair. Some of the first banks to fall were investment banks that were relatively unaffected by the legislation, and some of the banks that are doing relatively well mix risky and safe investments.
Freddie Mac and Fannie Mae are two banks that have been singled out as major characters in the banking debacle. Fannie Mae, more formally known as the Federal National Mortgage Association, came into existence through a congressional charter in 1938, during the Roosevelt administration, to back mortgage loans made by private banks.
In 1968, Congress privatized Fannie Mae, and it became just like any other bank in most aspects. One of the main ways in which Fannie still differed from typical banks is that it exclusively lends to lenders: a process known as “purchasing second.”
Freddie Mac, more formally known as the Federal Home Loan Mortgage Corp., was founded in 1970, during the Nixon administration to serve an almost identical function as Fannie May. Freddie was created in an attempt to keep Fannie from getting too large.
On September 7, 2008, the government revealed a plan to give Fannie and Freddie $200 billion in financial aid from the Treasury. This demonstrated that, although the agencies have been behaving like private institutions, they still are somewhat supported by the United States Government.
Although is has been assumed that the government would not let Fannie or Freddie fail, it has remained financially uninvolved in the banks’ business until now. Fannie and Freddie raised their own capital by selling stocks on the stock market like other banks (their call letters are FNM and FRE, respectively), and so far, they had not needed to take taxpayers’ money, and were only loosely connected with the government. In spite of the distance that the government has placed between itself and the two massive mortgage companies, President Bush said in his September 24 address to the nation, that the implicit assumption of government support, “allowed them [people who believed that Fannie and Freddie were backed by the government] to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk.”
The government’s bailout plan, which was approved by Congress (263 yea to 171 nay) on October 03, 2008, is another way that the government has stepped in to try to save the economy. Through the bailout plan, the government will spend $700bn to buy bad (or “toxic”) loans made by banks.
In an interview with CNBC, on October 1, 2008, Warren Buffet compared the American economy to “a great athlete that’s had a heart attack; the thing to do is apply a resuscitator, and there’s a resuscitator bill in Congress right now.” A BCC student said of the bailout bill currently in Congress, “I think it’s kind of more to save the a**** of CEOs.”