2008 Global Financial Crisis

Short answer

• The 2008 global financial crisis was a period of extreme stress in global financial markets and banking systems between mid 2007 and early 2009, in the words of the Reserve Bank of Australia. A downturn in the United States housing market was the catalyst, and linkages in the global financial system carried the trouble to other countries.
• In plain terms, many home loans were made to borrowers who were unlikely to repay them on the original terms, those loans were bundled into securities and sold to investors around the world, and banks and investors borrowed heavily to buy them. When house prices fell and repayments failed, those securities lost value, lenders stopped trusting each other, and credit froze.
• The sharpest week came in September 2008. Bear Stearns had already been absorbed in a Federal Reserve assisted transaction in March 2008. Lehman Brothers filed for bankruptcy on September 15, 2008. The next day, the Federal Reserve Bank of New York extended credit to AIG. Fannie Mae and Freddie Mac had been placed into conservatorship earlier that month.
• Governments responded with emergency lending, lower interest rates, guarantees, capital injections into banks, and fiscal stimulus. In the United States, Congress authorized the Troubled Asset Relief Program, known as TARP, in October 2008, initially at 700 billion dollars.
• The crisis then became a broad recession. The National Bureau of Economic Research dates the United States recession from December 2007 to June 2009, 18 months, the longest United States recession since World War II at that time. The International Monetary Fund forecast in July 2009 that world output would contract by 1.4 percent in 2009.
• There is no single agreed cause. The Financial Crisis Inquiry Commission concluded in January 2011 that the crisis was avoidable and resulted from failures in both the private and public sectors. This article therefore presents causes as attributed explanations, not as one settled verdict.

The 2008 global financial crisis is often told as a single dramatic week in September 2008. That week mattered, but it was the climax of a longer chain. House prices in the United States had already peaked, risky home loans had already been packaged and sold around the world, and several large financial firms had already run into trouble. This article follows that chain in order and explains the mortgage mechanics in plain language. This is history and explanation only. It is not financial advice, and it makes no recommendation about any investment, loan, or financial product.

Crisis And Recession: Two Different Things

The financial crisis was a breakdown in financial intermediation, the process by which savings are channeled to borrowers through banks, bond markets, and other institutions. When that process broke down, firms that looked solvent on paper could not borrow the cash they needed from day to day, investors could not sell assets at predictable prices, and trust between institutions collapsed.

The Great Recession was the broader decline in real economic activity that followed and overlapped with the financial crisis: falling output, falling trade, rising unemployment, and falling spending and investment. The National Bureau of Economic Research, which dates United States business cycles, determined that the recession began in December 2007 and ended in June 2009. It lasted 18 months, the longest United States recession since World War II up to that point. The committee added that calling June 2009 the trough did not mean conditions were favorable. It meant only that the declining phase had ended and an expansion had begun.

That distinction explains why unemployment kept rising after the recession officially ended. The United States unemployment rate was 5.0 percent in December 2007, according to the Bureau of Labor Statistics, and 9.5 percent in June 2009. The contemporary Bureau release for October 2009 put the rate at 10.2 percent in that month, while later Bureau summaries round the peak to 10.0 percent after revision. The honest statement is that the rate peaked at about 10 percent in October 2009. The Reserve Bank of Australia adds that the United States unemployment rate did not return to pre crisis levels until 2016, about nine years after the onset of the crisis.

Housing And Mortgage Mechanics In Plain Language

A mortgage is a loan secured on a home. The borrower repays over time, and if the borrower stops paying, the lender can eventually sell the home to recover part of the loan. That structure held together as long as borrowers could keep paying and homes could be sold for enough to cover most of the loan balance. Both conditions weakened before 2008.

A subprime mortgage, in the usage of the Reserve Bank of Australia, was a loan to a borrower with a higher risk of default, mainly because income and wealth were relatively low or because the borrower had missed repayments in the past. Subprime loans were not the whole mortgage market, but they grew fast, and they often depended on rising house prices. Some started with a low initial interest rate that later reset to a higher rate. Some were made with little verification of income. When prices fell or the reset rate arrived, many borrowers could not keep paying, and foreclosure, the legal process by which the lender takes and sells the home, rose.

Refinancing was central to the boom. When house prices rose, a borrower could often refinance, meaning replace an old loan with a new loan, sometimes borrowing against the higher value of the home. When prices fell, that exit closed. A borrower who owed more than the home was worth had few good options.

The second step turned individual home loans into a global problem. Lenders often did not keep the loans they made. Instead, thousands of mortgages were pooled together and sold to investors as mortgage backed securities, claims on the stream of repayments from that pool. The idea was diversification: even if some loans failed, most would keep paying. That logic failed when failures were correlated, meaning many loans failed at the same time for the same reason, namely falling house prices across much of the country at once. Some securities were then sliced into tranches, layers with different claims on the same pool, and further products repackaged slices of other securities. Each layer made it harder to know which home loans stood behind the product, and harder to price it when confidence fell.

Three mechanics amplified the losses. First, leverage, borrowing money to buy an asset, which magnifies losses as well as gains. Second, short term funding: many firms funded hard to sell assets with borrowing that had to be renewed daily, sometimes overnight, so a loss of confidence left them suddenly without cash. Third, credit default swaps, contracts in which one party paid a fee and another promised to pay if a specified debt instrument defaulted. AIG, through an unregulated subsidiary, had sold such swaps insuring counterparties against losses on debt instruments, many of them mortgage related, according to Federal Reserve History. When counterparties demanded collateral in September 2008, AIG could not post it without assistance.

Timeline: From A Housing Peak To A Global Panic

United States house prices peaked around mid 2006, according to the Reserve Bank of Australia. As prices fell, the share of borrowers who failed to make repayments began to rise. Stresses in the financial system first emerged clearly around mid 2007. Investors became less willing to buy mortgage backed securities and tried to sell their holdings. Prices of those securities declined, which reduced the net worth of their holders. Holders who had bought with short term loans then found it much harder to renew those loans, which forced more selling and further price declines.

In March 2008, Bear Stearns, one of the largest securities firms in the country with assets of approximately 400 billion dollars, deteriorated markedly between mid January and mid March. On March 13, 2008, Bear Stearns told the Federal Reserve that it expected it would not have enough funding or liquid assets to meet its obligations the following day. On March 14, the Federal Reserve authorized the Federal Reserve Bank of New York to extend credit to Bear Stearns through JPMorgan Chase, a loan of 12.9 billion dollars secured by assets valued at 13.8 billion dollars. On March 16, Bear Stearns accepted an offer to merge with JPMorgan Chase in a transaction facilitated by the Federal Reserve Bank of New York, which created Maiden Lane LLC to purchase approximately 30 billion dollars in illiquid Bear Stearns assets with a loan of approximately 29 billion dollars.

In September 2008, the crisis reached its sharpest phase. Fannie Mae and Freddie Mac, the housing government sponsored enterprises that support the United States mortgage market, were placed into conservatorship, a form of government control, in September 2008. Early on Monday, September 15, 2008, Lehman Brothers filed for bankruptcy after a weekend effort by the Federal Reserve, the Treasury, and the Securities and Exchange Commission to find a private sector solution failed. On the same day, Bank of America agreed to acquire Merrill Lynch. The next day, September 16, the Federal Reserve Bank of New York extended credit to AIG under emergency authority, and the Treasury received a 79.9 percent equity interest in AIG. That afternoon, a prominent money market fund announced that it could not redeem its shares at the usual price of 1 dollar per share because of losses on Lehman commercial paper it held. Investors withdrew money from money market funds, Treasury announced a temporary guarantee program for money market funds, and the Federal Reserve established a liquidity facility for asset backed commercial paper funds.

The panic then spread beyond individual firms, as investors pulled money out of banks and funds around the world because they did not know who might fail next, and confidence collapsed.

In October 2008, Congress passed the Emergency Economic Stabilization Act, which created TARP. Treasury states that Congress initially authorized 700 billion dollars for TARP in October 2008, later reduced to 475 billion dollars by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Treasury reports commitments of approximately 250 billion dollars to stabilize banking institutions, approximately 27 billion dollars to restart credit markets, approximately 82 billion dollars to stabilize the auto industry, and approximately 70 billion dollars to stabilize AIG, with some amounts ultimately canceled. Those are commitments, not a claim that every dollar was lost.

By late 2008 and into 2009, the policy response broadened from rescuing firms to supporting demand. The International Monetary Fund, in its July 2009 World Economic Outlook update, forecast that world output would contract by 1.4 percent in 2009 and expand by 2.5 percent in 2010, after growth of 5.1 percent in 2007 and 3.1 percent in 2008. Advanced economies were forecast to contract by 3.8 percent in 2009, and the United States by 2.6 percent. Those were forecasts, not final outcomes.

Key Institutions And Failures, One By One

Bear Stearns was an investment bank, not a commercial bank taking ordinary deposits. Its failure mode was a funding run: lenders lost confidence in its mortgage related assets and stopped providing the short term financing it needed. Its acquisition by JPMorgan Chase, described above, shows the pattern that would repeat: a firm that could not fund itself over a weekend, a facilitated merger, and a special vehicle to hold assets that could not be sold quickly.

Lehman Brothers was also an investment bank, and its case stands in contrast to Bear Stearns and AIG. Federal Reserve History states that Lehman did not receive an institution specific support program, although its primary dealer subsidiary did use special credit facilities. On September 12, 2008, that subsidiary had 18.5 billion dollars outstanding at the Term Securities Lending Facility, and on September 15 it borrowed 28 billion dollars through the Primary Dealer Credit Facility. Chairman Ben Bernanke later indicated, as summarized in Federal Reserve History, that collateral of sufficient quality and quantity was not available to assure repayment of any Federal Reserve loans to Lehman. That is the Federal Reserve explanation offered at the time, not a point on which all analysts agree, and whether Lehman could or should have been rescued remains debated.

AIG was a large insurance and financial services company with approximately 1 trillion dollars in reported assets in mid 2008, according to Federal Reserve History. Its trouble came mainly from credit default swaps sold through an unregulated subsidiary, not from ordinary insurance policies. The Federal Reserve and Treasury restructured the AIG arrangement on November 10, 2008, with Treasury purchasing preferred shares using TARP funds, and restructured it again in March 2009.

Fannie Mae and Freddie Mac did not originate most mortgages directly. They bought mortgages and guaranteed mortgage backed securities, supporting the flow of credit into housing. When losses mounted, the government placed them into conservatorship in September 2008, a legal state in which a conservator takes control to stabilize the enterprise. It is not the same as bankruptcy.

Citigroup and Bank of America received later, parallel support that should not be merged with the September rescues. Citigroup received joint support announced on November 23, 2008, protecting against unusually large losses on an asset pool of approximately 306 billion dollars, with a 20 billion dollar Treasury TARP investment. Bank of America received a parallel announcement on January 16, 2009, covering approximately 118 billion dollars in assets, mostly from the Merrill Lynch acquisition. That arrangement was never implemented, and in September 2009 Bank of America paid an exit fee of 425 million dollars to terminate it. On September 21, 2008, Goldman Sachs and Morgan Stanley, the last two independent investment banks, became bank holding companies, ending the standalone investment bank model that had dominated Wall Street.

Government Responses

Government responses are often summarized with the single word bailout, but that word hides different tools. The first was central bank lending. Central banks lowered interest rates rapidly to very low levels, often near zero, according to the Reserve Bank of Australia, lent large amounts to institutions with good assets that could not borrow in markets, and purchased securities to support dysfunctional markets and stimulate activity once rates were near zero, a policy known as quantitative easing. In the United States, the Federal Reserve created new facilities under emergency authority in Section 13(3) of the Federal Reserve Act. That authority was later amended by the Dodd-Frank Act so that lending under it is permitted only to participants in a program with broad based eligibility, with prior approval of the Secretary of the Treasury, and when several other conditions are met.

The second tool was capital injection and asset protection, mainly through TARP. Much of the money was used to inject capital into banks by purchasing preferred shares, rather than only buying troubled assets as first proposed. A loan must be repaid. A capital injection gives the government an ownership like claim that may be repaid or sold later. A guarantee promises to cover losses if they occur, which may cost nothing if losses stay below the threshold. Reporting an authorization as if it were a final loss therefore misleads in both directions.

The third tool was guarantees. Treasury announced a temporary guarantee program for money market funds, and governments in several countries guaranteed bank deposits and bank bonds to shore up confidence, according to the Reserve Bank of Australia. If depositors believe their money is safe, they do not all withdraw at once, and the bank does not have to sell assets at fire sale prices.

The fourth tool was fiscal policy, government spending and taxation to stimulate demand and support employment. In the United States, Congress passed a large fiscal stimulus package in early 2009. This article gives no single headline figure for it, because it combined spending, tax provisions, and aid to states, and summaries total it differently. The fifth, slower tool was regulatory reform. The Dodd-Frank Act was signed into law on July 21, 2010, and regulators required banks to operate with lower leverage and assess loan risk more closely, according to the Reserve Bank of Australia.

How The Crisis Spread Around The World

The crisis is called global because the financial linkages were global, not because every country had the same housing bubble. Foreign banks were active participants in the United States housing market during the boom, including by purchasing mortgage backed securities with short term United States dollar funding, according to the Reserve Bank of Australia. United States banks also had substantial operations in other countries. When the value of mortgage backed securities fell, a bank in Europe that held them suffered losses even if its own mortgage market had not collapsed, and when short term dollar funding dried up, it faced the same funding problem as a United States bank.

Some countries also had their own housing booms. The Reserve Bank of Australia names Iceland, Ireland, Spain, and some countries in Eastern Europe as places where developers and households borrowed excessively on the expectation that house prices would keep rising. In those countries, domestic booms collapsed alongside the global credit freeze, and bank rescues produced sovereign debt problems in the years that followed, most visibly in the euro area. This article does not give a full account of the later euro area debt crisis, which had its own causes and timeline.

Trade was a second channel. As demand collapsed in advanced economies, exports fell sharply. The International Monetary Fund July 2009 update forecast emerging and developing economy growth of 3.3 percent in 2009, down from 6.0 percent in 2008 and 8.3 percent in 2007. China and India continued to grow in that forecast, at 7.5 percent and 6.5 percent respectively in 2009, but far more slowly than before. The pattern was a sharp contraction in advanced economies, a sharp slowdown elsewhere, and a collapse in trade linking the two.

Australia is a useful contrast. The Reserve Bank of Australia states that Australia did not experience a large downturn or a financial crisis, although growth slowed and unemployment rose. It attributes the stronger performance to small bank exposures to the United States housing market, a small share of high risk lending, and resource exports to China. Global did not mean identical.

Aftermath

The financial panic eased in 2009, but the economic aftermath lasted years. The International Monetary Fund July 2009 update described the global economy as beginning to pull out of a recession unprecedented in the post World War II era, but with recovery expected to be sluggish, forecasting growth of 2.5 percent in 2010 after the 1.4 percent contraction forecast for 2009. Households that had lost homes, jobs, or savings did not resume spending at the old pace simply because banks were lending again. In the United States, foreclosures continued after the panic, and many households remained owing more than their homes were worth for years. This article gives no single national foreclosure total, because counts vary by definition and by whether they count filings, starts, or completed repossessions.

Public finances also changed. Governments that had guaranteed banks, injected capital, and increased spending took on large debts, and in some euro area countries bank rescue costs and falling tax revenues combined to create sovereign debt crises after 2008.

What Caused It: Attributed Explanations, Not One Verdict

The Financial Crisis Inquiry Commission issued its report on January 27, 2011, after reviewing millions of documents, interviewing over 700 witnesses, and conducting 19 days of hearings. The commission concluded that the crisis was an avoidable disaster caused by both private and public sector failings, including corporate mismanagement and excessive risk taking on Wall Street and widespread failures in government regulation. In the commission summary, the collapse of the housing bubble, fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages, was the spark that ignited a string of events leading to a full blown crisis in the fall of 2008. The commission also listed failures in regulation, breakdowns in corporate governance, excessive borrowing and risk taking, policy makers ill prepared for the crisis, and systemic breaches in accountability and ethics.

That majority account is not the only account from within the commission. Dissenting commissioners placed different weight on government housing policy, in particular affordable housing goals imposed on Fannie Mae and Freddie Mac, arguing that those goals pushed the enterprises to lower underwriting standards. Other analysts placed more weight on monetary policy or on global capital flows, arguing that savings inflows kept interest rates low and funded the housing boom. The Reserve Bank of Australia lists three groups of factors without ranking them as a single cause: excessive risk taking in a favorable environment, increased borrowing by banks and investors, and regulation and policy errors.

A responsible one sentence summary is this: the housing bubble and its collapse were the spark, in the commission majority phrase, but the fuel was a financial system that had borrowed heavily, packaged risk opaquely, rated it as safe, and funded it with short term money, in a regulatory environment that did not restrain those practices in time. That is a synthesis of the attributed accounts above, not a quotation from any single source.

Frequently Asked Questions

What was the 2008 global financial crisis in one paragraph?

It was a period of extreme stress in global financial markets and banking systems between mid 2007 and early 2009, in the Reserve Bank of Australia description. A downturn in the United States housing market was the catalyst. Risky mortgages had been packaged into securities sold around the world, and banks and investors had borrowed heavily to buy them. When house prices fell and repayments failed, those securities lost value, trust collapsed, credit froze, and the financial crisis became a broad recession.

What caused the 2008 financial crisis?

No single source gives a single settled cause. The Financial Crisis Inquiry Commission majority concluded that the crisis was avoidable and resulted from private and public sector failings, including corporate mismanagement, excessive risk taking, and widespread failures in regulation, with the housing bubble collapse as the spark. Other accounts place different weight on housing policy, monetary policy, global capital flows, and private risk taking.

What is a subprime mortgage?

A subprime mortgage was a home loan to a borrower with a higher risk of default, mainly because income and wealth were relatively low or because the borrower had missed repayments in the past, in the Reserve Bank of Australia description. Such loans often depended on rising house prices or on refinancing before an initial low rate reset to a higher rate. When prices fell and refinancing closed, many borrowers could not keep paying, and foreclosures rose.

Why did Lehman Brothers fail while Bear Stearns and AIG received support?

Lehman Brothers filed for bankruptcy on September 15, 2008, after a weekend effort to find a private sector solution failed. Bear Stearns had been acquired by JPMorgan Chase in a Federal Reserve assisted transaction in March 2008, and AIG received Federal Reserve Bank of New York credit on September 16, 2008. Federal Reserve History records that Lehman did not receive an institution specific support program, and that Chairman Bernanke later indicated that collateral of sufficient quality and quantity was not available to assure repayment of any Federal Reserve loans to Lehman. Whether that decision was right remains debated.

What was TARP?

The Troubled Asset Relief Program was created by the Emergency Economic Stabilization Act in October 2008. Congress initially authorized 700 billion dollars for TARP, later reduced to 475 billion dollars by the Dodd-Frank Act, according to Treasury. Treasury reports commitments of approximately 250 billion dollars to stabilize banking institutions, approximately 27 billion dollars to restart credit markets, approximately 82 billion dollars to stabilize the auto industry, and approximately 70 billion dollars to stabilize AIG, with some amounts canceled. Authorization and commitment are not the same as final cost.

How long did the Great Recession last, and how bad was unemployment?

The National Bureau of Economic Research dates the United States recession from December 2007 to June 2009, 18 months, the longest United States recession since World War II at that time. The United States unemployment rate was 5.0 percent in December 2007 and 9.5 percent in June 2009, according to the Bureau of Labor Statistics. The contemporary Bureau release put the rate at 10.2 percent in October 2009, while later summaries round the peak to 10.0 percent after revision. The safe statement is that unemployment peaked at about 10 percent in October 2009, and the Reserve Bank of Australia notes that it did not return to pre crisis levels until 2016.

Sources & references

• Reserve Bank of Australia. The Global Financial Crisis, Explainer. Period mid 2007 to early 2009, causes, unfolding, policy responses, global spread, Australia contrast, and slow recovery. https://www.rba.gov.au/education/resources/explainers/the-global-financial-crisis.html
• Federal Reserve History. Support for Specific Institutions. Bear Stearns, Lehman Brothers, AIG, Citigroup, and Bank of America support, dates, amounts, and emergency lending authority. https://www.federalreservehistory.org/-/media/Project/FedHistory/FedHistory/Documents/essaysPDFs/Support-for-Specific-Institutions-_-Federal-Reserve-History.pdf
• International Monetary Fund. World Economic Outlook Update, July 8, 2009. World output forecasts, advanced economy and United States forecasts, emerging economy forecasts, and trade. https://www.imf.org/en/publications/weo/issues/2016/12/31/contractionary-forces-receding-but-weak-recovery-ahead
• National Bureau of Economic Research. Business Cycle Dating Committee announcement, September 20, 2010. Recession December 2007 to June 2009, 18 months, longest since World War II. https://www.nber.org/cycles/sept2010.html
• United States Bureau of Labor Statistics. The Recession of 2007 to 2009, Spotlight on Statistics, and The Employment Situation, October 2009, news release USDL-09-1331. Unemployment rates December 2007, June 2009, and October 2009, including the contemporary 10.2 percent figure and later rounded summaries. https://www.bls.gov/spotlight/2012/recession/pdf/recession_bls_spotlight.pdf
• United States Department of the Treasury. Troubled Asset Relief Program. Initial 700 billion dollar authorization in October 2008, reduction to 475 billion dollars by the Dodd-Frank Act, and commitments by program area. Program summary page as summarized in Treasury material checked for this article. https://home.treasury.gov/data/troubled-assets-relief-program/about-tarp
• Financial Crisis Inquiry Commission. Report issued January 27, 2011, as summarized by the Harvard Law School Forum on Corporate Governance. Avoidable disaster conclusion, private and public sector failings, housing bubble spark. https://corpgov.law.harvard.edu/2011/01/27/the-financial-crisis-inquiry-commission-report/
• Federal Housing Finance Agency conservatorship material on Fannie Mae and Freddie Mac (September 2008); Federal Reserve testimony on the Bank of America-Merrill Lynch acquisition (agreement announced September 15, 2008); and Federal Reserve press release, September 21, 2008, on Goldman Sachs and Morgan Stanley becoming bank holding companies.