Can the government control a stock market crash?

The Subprime Fallout

Foreclosures on homes, like this one in Miami, were expected to hit 1 million in 2008.
Foreclosures on homes, like this one in Miami, were expected to hit 1 million in 2008.
Joe Raedle/Getty Images

The stock market is all about perception. When the market is perceived as healthy -- meaning the dollar is strong, the trade deficit is narrow, and the value of companies is high -- investment begets investment. When things look bleak, however, a chain reaction of misfortune tends to occur. The failure of one section of the economy can lead to another and so on. In 2007, things began to look bleak on the American stock market. This was thanks in large part to the subprime mortgage fallout.

Subprime mortgages offered home loans to borrowers who posed a high credit risk. Often, these loans were given with attractive terms, like low initial interest rates and no down payment. In many cases, they were given for amounts people couldn't otherwise afford. Many of these subprime mortgages were issued as adjustable rate mortgages (ARMs). The interest rates on these loans reset, generally after two years, and at a higher rate. This increased monthly mortgage payments, often to amounts a homeowner couldn't afford. As a result, home foreclosures in the United States increased 75 percent from 2006 to 2007 [source: CNN Money].

These foreclosures may not have had the sweeping effect on the American economy that they did had they not carried so many implications for other areas of the financial world. Under previous banking regulations, banks simply issued mortgages and kept them, accepting payments over 15 or 30 years until the loan was paid off. But in the mid-1990s, restrictions covering loans were eased as part of an effort to extend home ownership to more Americans. The result was that mortgages could be bought and sold easily. Many subprime mortgages were purchased by stock brokers, lumped together into portfolios, and sold as securities [source: Federal Reserve Bank].

Because financial institutions like investment banks and securities companies had purchased these mortgages, the risk from any fallout was spread across the financial spectrum.

Let's look at this dispersal like a metastasizing cancer. As interest rates on ARMs reset and increased, so, too, did monthly payments on home loans. Combined with additional factors, like auto industry workers who were part of a massive layoff and real estate speculators who had purchased homes with ARMs, some people simply walked away from their homes -- and the loans that went with them [source: Federal Reserve Bank].

But the huge mortgage lenders who actually paid out the money to borrowers to purchase these homes suddenly found that the revenue from their monthly payments was drying up -- quickly. The largest U.S. home loan lender, Countrywide, reported $1.5 billion in lost revenue during the second half of 2007 [source: AP]. In 2006, before the subprime fallout, Countrywide made more than $2.5 billion in profits [source: Fortune]. And since nonconsumer banks and institutions had become so heavily invested in the subprime market, almost all areas of finance became infected with worthless mortgages. Even worse, because investors around the world had purchased subprime mortgages as securities, the whole global economy suffered from the American subprime fallout.

Huge investment banks and major lenders began to go under. People braced for the worst: a stock market crash. Then, the U.S. government stepped in to try to save the sinking ship that was the American economy. But is there anything a government can do to control a stock market crash? Read on to find out.