The Stock Market Crash of 2008

During the years preceding the credit market collapse, the sub-prime mortgage industry thrived. Individuals with poor credit were given access to loans they really couldn't afford. But as long as home prices were on the rise, these poor lending practices were simply ignored. Lenders could afford to write bad loans as long as the homeowner's equity outpaced their desire for new debt. If borrowers were to fail to pay back their loans, lenders could always foreclose on the home, since it was an asset with ever-increasing value.

The credit market's problems began when housing prices started to fall in 2007. Homeowners frequently found themselves with underwater loans. They owed lenders more than the home was worth. When faced with these facts, homeowners no longer feared the threat of foreclosure. Even more disturbing was the fact that some families abandoned their homes; choosing to start their lives anew elsewhere rather than worry about paying off their debts.

Bear Stearns' Collapse

As mortgage defaults started to rise, the national economy started to falter, and fear crept into the credit markets. Despite the efforts of the Federal Reserve, the destabilization of the credit market quickly spread to the national financial system. Lenders began to fear borrowers could no longer repay their loans. Bear Stearns was the first investment bank to fall victim to this fear. Investors, as well as other financial institutions, began to worry that money borrowed by Bear Stearns would not be repaid, and they began pulling money back from Bear Stearns. On March 13, 2008, Bear Stearns advised the Federal Reserve that its liquidity position had deteriorated, and that it would file for bankruptcy unless alternative sources of funds were made available. Two days later, Bear Stearns agreed to merge with JP Morgan Chase in a deal that wiped out 90% of Bear Stearns' market value.

Fannie Mae and Freddie Mac Fall

By the year 2008, the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) either owned or guaranteed nearly $6 trillion in mortgage loans. With a mortgage crisis in the United States, these two corporations quickly began showing signs of financial distress. On September 7, 2008, the governing authority over these two agencies, the Federal Housing Finance Agency, or FHFA, placed both Fannie Mae and Freddie Mac under their conservatorship. In addition, the U.S. Treasury Department began supplying funds to help stabilize these companies, raising the national debt ceiling by $800 billion in the process.

On September 14, 2008, Bank of America agreed to acquire Merrill Lynch for $50 billion, as a second wave of volatility began in the financial community. On September 15, 2008, concerns over the ability of financial institutions to cover their exposure in both the sub-prime loan market as well as credit default swaps led to further market instability. That same day, Lehman Brothers would be forced to file for Chapter 11 bankruptcy protection. On September 16, 2008, American International Group would fall victim to a liquidity crisis, as AIG's shares lost 95% of their value and the company reported a $13.2 billion loss in just the first six months of the year. By September 22, 2008, AIG was removed from the DJIA, replaced by Kraft Foods.

Although the market arguably started its crash back on October 1, 2008, the Black Week began on October 6th and lasted five trading sessions. During that week, the Dow Jones Industrial Average would fall 1,874 points or 18.1%. In that same week, the S&P 500 would fall more than 20%. After a brief uptick in mid-October, the market would begin a second decline later in that same month. On October 24th, the Dow would fall 312.30 points to 8,378.95. This was its lowest level since April 25, 2003. The S&P 500 would fall 31.24 to 876.77, its lowest level since April 11, 2003. Finally, the Nasdaq Composite would fall 51.88 points to 1,552.03, its lowest level since May 23, 2003.

Many market theorists believe that stock market crashes feed on themselves. Once destabilization of the stock market occurs, this incident may be followed by a series of events that trigger an even larger decline in the market. One of these events has to do with investor fear, and the other has to do with stop losses.

Investor Fear and Market Losses

Investors may reach a "loss threshold" where they are unwilling to continue to risk additional losses. Unfortunately, selling stocks well into a bear market is a good way to lock in losses, and this type of panic selling often backfires as an effective strategy to combat such losses in a down market.

Stop Loss Orders

Investors can place stop loss orders in advance with brokers. These orders programmatically sell a security when it reaches a certain price. The intention of a stop loss order is to limit the potential decline of a security's value. During the onset of a market crash, stop loss orders can lead to a sell-off of stocks, and an even further decline in stock prices. As the market gets flooded with sell orders (from stop loss orders), the prices of the underlying stocks begin to drop rapidly as the supply of stocks overwhelms their demand.

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