Kenneth R. Szulczyk
most severe recession since the Great Depression. Your author calls this the 2008 Financial
Crisis, when pandemonium struck the financial world.
A stock market crash occurs from a financial bubble. A bubble is a dramatic, rapid rise in
asset prices. As the asset prices reach a peak, then the prices rapidly fall, bankrupting financial
institutions that became caught in the market. The United States along with other industrial
countries experienced a strong real estate bubble that popped in 2007. Collapsing housing
bubble triggered both the 2007 Great Recession and the 2008 Financial Crisis. Unfortunately,
real estate prices began falling while both foreclosures and the unemployed were soaring.
Consequently, both the investment banks and commercial banks earned enormous losses from
the mortgage market as homeowners stopped paying their mortgages. Banks refused to lend to
anyone, causing a credit crunch. A credit crunch means financial institutions stop lending to
themselves and the public, disrupting business activities, such as construction and
manufacturing.
Investment banks became involved in mortgages because they packaged mortgages into
new exotic securities, which was tremendously profitable before 2007. Then stock prices began
plummeting during 2008 until they had lost half their value. Some banks were particularly hit
hard like Citigroup and Bank of America as their stocks traded below $1 per share, which was a
significant drop. Investment bank, Lehman Brothers, declared bankruptcy, and it closed its
doors to the financial world. Unfortunately, many Americans were on the verge of retirement,
and many experienced a 50% or more decline in their pension funds, causing many workers to
delay retirement. (We study the 2008 Financial Crisis in detail in Chapter 18 after students learn
derivatives.)
Stock market embodies more psychology than logic. Investors are human! When investors
see the Dow Jones soaring, they invest more money into the stock market. As investors dump
more money into the stock market, the stock prices continue rising. If investors see the stock
market prices began falling, then they pull their money out of the stock market, and stock prices
continue falling. If stockholders become afraid, they cash in all their stocks at once, causing the
stock prices to plummet. Thus, the market moves in cycles, being driven by public’s psychology
and their expectations about future stock prices.
Investment Institutions
Investment institutions include mutual funds and finance companies. A mutual fund
manager groups together funds from many investors and invests the money in a variety of
stocks. Consequently, a mutual fund diversifies stocks, and it lowers investors’ risk. For
example, you start your own mutual fund and offer investors a chance to invest in this fund. You
take the money and buy 30 different corporate stocks. The Coca-Cola stock rises one day while
the value of IBM stock falls. Overall, the average of the fund’s 30 stocks should earn a return to
your fund and to the investors. If you bought only Kmart corporate stock, you would lose your
investment if this company bankrupts.
Mutual fund companies have different strategies and characteristics, and well-known
mutual fund companies include Fidelity, Vanguard, and Dreyfus. Mutual fund companies
develop strategies where they only buy stock in certain industries, large companies, or foreign