A rise in housing foreclosures added to the gloomy picture. Defaults on home mortgages reached an all-time high in September 2007. Particularly hard-hit were people who had taken out adjustable-rate mortgages, arrangements that enabled them to pay monthly mortgages at a relatively low interest rate for the first few years of the mortgage. But after the rates rose, many of these homeowners could no longer afford to make their monthly payments. Many of the foreclosures affected people who received so-called subprime mortgages—that is, loans made to people whose credit ratings or income usually disqualify them for a home purchase loan. By the second quarter of 2008, a record 1.2 million homes were in foreclosure. A report by the U.S. Congress estimated that as many as 2 million families with subprime mortgages would lose their homes due to their inability to meet rising mortgage payments.

Further complicating the growing housing crisis was the existence of new financial instruments known as derivatives, along with mortgage securities or bonds, connected to the secondary mortgage market. Beginning in the 1970s banks began selling mortgages to other lenders as a way of raising cash, abandoning the long-standing practice of holding on to a mortgage until it was paid off while using the property as collateral. As this trend of pooling mortgages into securities continued, banks began to create new financial instruments in the 1990s known as collateralized debt obligations (CDOs), a type of mortgage security. Many of these CDOs mixed together mortgages that represented different levels of risks from low-risk to high-risk subprime mortgages. By one estimate the amount of subprime mortgages contained in these mortgage securities increased from $56 billion in 2000 to $508 billion in 2005, when mortgage borrowing reached its peak.

The extent of presidential power in relation to the U.S. system of checks and balances spurred controversy during Bush’s second term. Throughout his prosecution of the wars in Afghanistan and Iraq, Bush claimed that he had wide latitude as commander in chief to protect national security. Those claims were the basis for denying Geneva Convention protections to prisoners held at Guantánamo Bay, Cuba. In 2006 Bush claimed that he had the authority as commander in chief and under the congressional resolution that authorized military force in Afghanistan to order the National Security Agency to eavesdrop on the overseas communications of U.S. citizens and nationals. The secret program, begun after the September 2001 terrorist attacks, was disclosed by a 2006 report in the New York Times.

US in Afghanistan. Encarta

Some congressional critics said the 1978 Foreign Intelligence Surveillance Act required judicial review of electronic eavesdropping in such cases, making the program illegal. When the housing bubble burst and home prices started falling, financial institutions were in the position of not knowing the real value of the mortgage securities they held. In March 2008 the Federal Reserve announced a $200-billion loan program for about 20 large investment banks to reassure investors worried about losses in the mortgage market. The Fed also extended an additional $30 billion for J. P. Morgan Chase & Co. to acquire a leading investment bank known as Bear Stearns, which was threatened with bankruptcy due to losses in the mortgage market.

The financial crisis came to a head in September 2008, right in the midst of the presidential campaign. First, the federal government placed the mortgage lending institutions known as Fannie Mae and Freddie Mac in a “conservatorship,” which basically meant that they would file for bankruptcy reorganization under government protection. Then, in mid-September, the long-standing investment bank Lehman Brothers filed for bankruptcy, citing overexposure to bad mortgage finance and real estate investments. The same day the Bank of America Corporation announced that it was acquiring prominent Wall Street firm Merrill Lynch Before the month was over, the Federal Reserve, in an unprecedented intervention in the private sector, acquired an 80 percent stake in the world’s largest insurance firm, American International Group (A.I.G.), for $85 billion; the nation’s largest savings and loan institution, Washington Mutual, was seized by federal regulators and then sold to J. P. Morgan Chase & Co. in the largest bank failure in U.S. history; and the banking operations of the Wachovia Corporation went on the block, leaving the country with three major banks controlling 30 percent of all deposits. Topping it all off, when the U.S. Congress balked at passage of a $700-billion bailout proposal for the nation’s financial institutions, the stock market’s Dow Jones Industrial Average saw its largest single-day point drop in history, declining by 778 points as investors lost trillions of dollars in stock value.

By October it was being called the worst financial crisis since the Great Depression. Because financial institutions and firms around the world had invested in U.S. mortgage securities and other damaged financial instruments known as derivatives, the crisis became global and involved the central banks of other countries, especially those of the United Kingdom, France, Germany, and Spain. With so many unknowns about the extent of the crisis, lending institutions stopped lending, creating a credit crisis that promised to dry up loans for both businesses and consumers. To address this credit crisis, the U.S. Department of the Treasury and the Federal Reserve persuaded the U.S. Congress to pass the $700-billion bailout, or rescue, package, granting unprecedented powers to the secretary of the treasury, Henry Paulson.

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Among these powers was the virtually sole discretion to spend the money as he saw fit, including to aid foreign banks, although some oversight was to be provided by Congress and by regulators. Haltingly at first but then with gathering speed, the Treasury Department and the Federal Reserve used their new powers to take a number of other extraordinary measures. Tapping into $250 billion from the rescue package, the Treasury purchased dividend-paying, preferred shares in at least eight of the nation’s largest banks. An additional $125 billion was allocated for thousands of midsize and small banks. By purchasing a stake in these institutions, rather than just buying up their troubled assets as the government had originally planned, the bailout held out the prospect that taxpayers might eventually recover some of the investment. However, the share-buying plan fell short of nationalization because the government held nonvoting shares in the banks, meaning that it had no say in their management.

Other measures included a federal government guarantee of new bank debt over a three-year period and a mandate for the Federal Deposit Insurance Corporation (FDIC) to cover all of the deposits of small businesses and to insure each individual depositor’s accounts up to $250,000 through the period ending in December 2009. The FDIC also extended temporary insurance for the first time to interbank lending in an attempt to loosen the credit markets and boost borrowing. Despite these and other steps, however, most economists predicted that the U.S. economy was sure to enter a recession, and some said that benchmark had already been reached. Encarta