2008 Financial Crisis Explained

Emma Walkley
Jul 18, 2021
7 min read

The 2008 financial crisis shook the global economy. What began as a crisis regarding

subprime mortgage bonds later developed into a full-scale global financial recession,

renowned for being the worst economic disaster since the Great Depression. Although it has

been a decade since the financial crisis hit, the effects of the recession are still felt today.

The global recovery has been fairly weak in comparison to historical standards. Many have

continued to suffer long after with austerity measures being implemented and the devastating effects on employment, housing, and businesses. As high-risk loans are being offered once again, questions have arisen surrounding the stability and transparency of the global banking systems in which were previously trusted. Twelve years later people are wondering how this type of economic crisis can be avoided in the future. It is critical to explore and examine the reasons behind the financial crisis and the importance of policy from an economist’s perspective to ensure it does not happen again.

Causes of the Crash

The power that comes with having a decade’s hindsight discloses the causes for the crisis that upheaved the world’s financial system. Alongside irrationally exuberant financiers who had claimed a way to banish risk when they had in fact simply lost track of it, there are a number of clear-cut rationales behind the crisis. Although the relative importance is a matter of dispute among economists, there is general consensus regarding the factors that played a

predominant role.

Deregulation

In 1999, the depression-era legislation Glass-Steagall Act that separated investment banking

from retail banking was partially repealed. The repeal allowed banks to use deposits to invest in derivatives. A derivative is a contract between two parties that get its value from an

underlying asset. Banks, security firms, and insurance companies merge, resulting in the

formation of banks that were ‘too big to fail’. Big banks had the resources to become

advanced at the use of such complicated derivatives. The banks with the most complicated

financial products made the most money, which enabled them to buy out smaller, safer banks. Bank lobbyists stated that deregulation was needed in order to compete with foreign firms, promising to invest only in low-risk securities to protect their customers.

The following year, the Commodity Futures Modernisation Act exempted credit default

swaps and other derivatives from regulations. This legislation overruled state laws that had

formerly prohibited such gambling and specifically exempted trading in energy derivatives.

Texas Senator Phil Gramm, who sat as Chairman of the Senate Committee on Banking,

Housing, and Urban Affairs, advocated for the passage of bills in both cases. He listened to

lobbyists from the energy company, Enron. Enron was a major contributor to Senator

Gramm’s campaigns as his wife sat on the board.

Correspondingly, in 2004 the Securities and Exchange Commission (SEC) weakened the net-

capital requirement (the ratio of capital, assets, debt, or liabilities that banks are required to

maintain as a safeguard against insolvency), which encouraged banks to make bigger

investments into a mortgage-backed security (MBS). The substantial profits gained by banks as a result of the SEC’s decision came at the expense of their portfolios being exposed to

significant risk as the asset value of MBSs was implicitly premised on the continuation of the

housing bubble.

Securitization and the Growth of Subprime Mortgages

The Federal Reserve reduced the federal funds rate 12 times between May 2000 and

November 2002, from 6.5% to 1.25% in anticipation of a mild recession. The substantial

decrease of rates enabled banks to extend consumer credit at a lower prime rate and

encouraged them to lend to subprime (high risk) customers, though at a higher rate. This also lowered interest rates in adjustable-rate mortgages, leading to many homeowners who

couldn’t afford conventional mortgages being approved for interest-only loans. In turn, the

percentage of subprime mortgages more than doubled from 6% to 14% of all mortgages

between 2001 and 2007.

The reduction in the rate also created an asset bubble in real estate in 2005, more commonly

known as the housing bubble. The demand for mortgages drove up demand for housing,

which homebuilders struggled to meet, causing a rapid increase in house prices to levels way beyond their fundamental value. With cheap loans, many bought homes as investments to sell as prices continued to rise. Those with adjustable-rate loans didn’t realize that the rates would reset in 3-5 years. As the Fed began to increase rates from 1.25% in 2002 to 5.25% in June 2006, subprime homeowners were hit with payments they couldn’t afford.

Securitization was a prime contributor to the growth of subprime lending in the years leading up to the financial crisis. Securitization is a practice whereby hedge funds and others sold mortgage-backed securities, collateralized debt obligations, and other derivatives. A

mortgage-backed security is a financial product whose price is based on the value of the

mortgages that are used for collateral. Once you got a mortgage from a bank, it sold it to a

hedge fund on the secondary market. Hedge funds then bundled together thousands of

subprime mortgages and other less risky forms of consumer debt, selling them in capital

markets as securities (bonds). Bonds consisting primarily of mortgages became known

as mortgage-backed securities, or MBSs, which entitled their purchasers to a share of the

interest and principal payments on the underlying loans.

Selling subprime mortgages as MBSs was considered an efficient way for banks to increase

their liquidity while purchasing MBSs was viewed as a good way for investors to diversify

their portfolios and earn money. Since the banks sold mortgages, they could make new loans with the money they received. Payments made would be sent to the hedge fund, which would send it to their investors. Each party would take a cut along the way as it was risk-free for the bank and the hedge fund, hence why they were so popular.

Investors took all the risk by default but had insurance in the form of credit default swabs.

These were sold by solid insurance companies, such as the American International Group.

The insurance allowed investors to buy up derivatives without worry. A derivative backed by

the combination of both real estate and insurance was very profitable. As the demand for

these derivatives grew, so did the banks; demand for more and more mortgages to back the securities. To meet this demand, banks and mortgage brokers offered home loans to just about anyone.

The Collapse of America’s Financial Market

It was difficult to determine the extent of subprime debt in any MBS and the strength of bank portfolios containing MBSs as assets as MBSs were typically sold in pieces, mixed with other debt, and resold. Consequently, banks began to doubt one another’s solvency, which led to a freeze in the federal funds market, and that in turn had the potential to cause disastrous consequences. Thus, the Fed began to purchase federal funds in the form of government securities to provide banks additional liquidity, thereby reducing the rate which had exceeded its 5.25% target. Central banks in disparate parts of the world conducted similar operations. However, the Fed’s intervention failed to stabilize the US financial market and was forced to directly reduce the rate. At the same time, the fifth-largest mortgage lender in the United Kingdom, Northern Rock, ran out of liquid assets and appealed to the Bank of England for a loan. News of the bailout created panic among depositors and resulted in the first bank runs in the United Kingdom in 150 years.

By January 2008, the crisis in the US was worsening as Bank of America agreed to purchase

one of the countries leading mortgage lenders for $4 billion in stock. In March, the prestigious Wall Street investment firm Bear Stearns had exhausted its liquid assets and was

consequently purchased by JPMorgan Chase, which had also sustained billions of dollars in

losses. In fear of Bear Stearns’s bankruptcy threatening other major banks from which it had

borrowed, the Fed facilitated the sale by assuming $30 billion of the firm’s high-risk assets.

By summer Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the

Federal Home Loan Mortgage Corporation), the federally chartered corporations that

dominated the secondary mortgage market (the market for buying and selling mortgage

loans) were in serious trouble. Both institutions had been established to provide liquidity to

mortgage lenders by buying mortgage loans and either holding them or selling them—with a guarantee of principal and interest payments—to other banks and investors. Both were

authorized to sell mortgage loans as MBSs. Once MBSs created from subprime loans lost

value and eventually became toxic, Fannie Mae and Freddie Mac suffered enormous losses

and faced bankruptcy. To prevent their collapse, the U.S. Treasury Department nationalized

both corporations in September, replacing their directors and pledging to cover their debts,

which then amounted to some $1.6 trillion.

In the same month investment bank Lehman Brothers filed the largest bankruptcy in US

history with $639 billion in assets. Its failure created lasting turmoil in financial markets

worldwide, severely weakened the portfolios of the banks that had loaned it money, and

fostered new distrust among banks, leading them to further reduce interbank lending. The Fed loaned the company $85 billion to cover losses related to its sale of credit default swabs.

By this time, there was general agreement among economists and Treasury Department

officials that a more forceful government response was necessary to prevent a complete

breakdown of the financial system and lasting damage to the U.S. economy. In September

the George W. Bush administration proposed legislation, the Emergency Economic

Stabilization Act (EESA), which would establish a Troubled Asset Relief Program (TARP).

Under this, the Secretary of the Treasury, Henry Paulson, would be authorized to purchase

from U.S. banks up to $700 billion in MBSs and other “troubled assets.”

It soon became apparent that the government’s purchase of MBSs would not provide

sufficient liquidity in time to avert the failure of several more banks. Paulson was therefore

authorized to use up to $250 billion in TARP funds to purchase preferred stock in troubled financial institutions, making the federal government a part-owner of more than 200 banks by the end of the year. A number of quantitative easing programs were incorporated to

stimulate economic growth with other countries adopting similar interventions. By the time

quantitative easing programs were officially ended in 2014, the Fed had injected $4 trillion

into the US economy.

What Is Being Done to Prevent Another Crisis?

There is now general consensus taken by the Fed to protect the US financial system and

prevent another global economic catastrophe. Recovery was aided by a program proposed

by the Obama administration that sought a %787 billion stimulus and relief program. In

2010, Congress adopted the Wall Street Reform and Consumer Protection Act (the Dodd-

Frank Act), which instituted banking regulations to prevent another financial crisis and

created a Consumer Financial Protection Bureau, which was charged with regulating

subprime mortgage loans and other forms of consumer credit. After 2017, however, many

provisions of the Dodd-Frank Act were rolled back or effectively neutered by a Republican-

controlled Congress and the Donald J. Trump administration, both of which were hostile to

the law’s approach. Below are more informational articles on how another financial crisis can

be avoided.

How Another Financial Crisis Can Be Avoided/How to Help

Sources

2008 Financial Crisis Explained

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