What caused the financial crisis of 2007-2008? How did it start?
Mortgages sold to American homeowners were responsible for a series of events that caused billions of dollars in investment losses around the world, nearly collapsing the global financial system and leading to the Great Recession, the worst downturn economy since the Great Depression.
It all started with the US housing market, which in the 1990s and early 2000s was the place to be – scorching demand had driven home prices up by more than 100% in less than 10 years. Housing-related industries accounted for almost half of all new jobs created, and housing starts had more than doubled.
US National S&P/Case-Shiller House Price Index
Credit expansion and low interest rates backed by the Federal Reserve had created the perfect environment for new homebuyers. But unfortunately, a lack of oversight at both ends of the financial spectrum would lead to massive defaults.
On the consumer side, predatory lenders had targeted low-income people with the prospect of owning their own homes through a new class of mortgage lending: subprime mortgages. These loans were given to borrowers with less than perfect credit scores, often requiring no proof of income or even a down payment. They featured adjustable rates that started low, but “reset” to a higher rate each year or whenever prevailing interest rates increased. Subprime mortgages were poorly explained and complex in nature. Borrowers didn’t understand what they were getting into, and when the Fed began a series of interest rate hikes to curb inflation between 2004 and 2006, millions of people couldn’t pay their mortgages sharply. more expensive and ended up failing. The banks had to cover the losses, but they had an even bigger problem on their hands.
How did banks contribute to the financial crisis?
Banks simply make their profits by selling loans and earning interest on their loans. They can also make money through loan securitization, in which groups of loans are bundled into interest-bearing packages called mortgage-backed securities (MBS).
One type of MBS, known as collateralized mortgage bonds (CMOs), has been subdivided into tranches, or tranches, containing thousands of subprime mortgages. Each tranche had its own credit rating and its own performance. The AAA-rated categories were the highest rated and considered the least likely to default as borrowers were deemed able to meet their financial commitments. Pooled loans rated BBB or lower were riskier and more likely to default; yet they also offered the highest returns.
CMOs were sold to investment banks, who saw this type of securities as another investment vehicle and traded them around the world for profit. In fact, the main buyers of CMOs were institutional investors, such as hedge funds, pension funds, money market funds, and insurance companies. These groups included what was known as shadow banking, which had little regulatory oversight. Some investment banks bundled AAA-rated securities with lower-quality securities, and these lots were presented as prime securities when sold to investors.
It all continued until an asset bubble formed in housing, with speculation driving prices higher and higher. The bubble peaked in early 2006, then quickly receded.
What happened when the housing bubble burst?
A number of things happened when the housing bubble burst dramatically:
- The Federal Reserve had raised the federal funds rate 17 times from 1.0% to 5.25%. Homeowners suddenly found themselves with mortgages that cost more than their home was worth, and housing demand plummeted.
- At the same time, interest rates on subprime mortgages rose and millions of homeowners couldn’t repay and defaulted.
- Because millions of home loans could not be repaid, subprime mortgage lenders went bankrupt. New Century Financial Corp., one of the largest issuers of subprime mortgages, was the first to fall, and dozens more followed.
- When the housing bubble burst, the assets that supported them became worthless; CMO bond funding also collapsed. Investment banks and the shadow banking sector have been unable to raise funds in the securities markets. Panic erupted, causing a liquidation of “toxic debt” around the world. Banks experienced a credit crunch, which meant they no longer had the funds to lend to each other, sending many to the brink of insolvency. The securities grouped with the highest ratings fell as the value of the lower-rated securities fell.
- On September 15, 2008, Lehman Brothers, one of the largest investment banks in the world and heavily indebted in subprime debt, declared bankruptcy, the largest in US history. The federal government had to step in with emergency capital to avert a global financial meltdown, subsequently bailing out other companies, such as insurance company AIG, and causing Bank of America to buy the banker from Merrill Lynch investment for $50 billion in stock. It also provided emergency capital to keep Bear Stearns, another investment bank involved in packaging MBS, afloat.
- In response to the collapse of Lehman Brothers, the Dow Jones Industrial Average fell more than 500 points at one point in September 2008, for its biggest one-day drop in nearly a decade. Fearing bank runs, investors withdrew $196 billion from money market accounts. The economy plunged into an 18-month freefall known as the Great Recession.
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How did Fannie Mae and Freddie Mac contribute to the financial crisis?
Government-sponsored companies like Fannie Mae and Freddie Mac had a mandate to make homeownership affordable by providing liquidity to banks and mortgage providers, who could, in turn, create even more Mortgages.
Fannie Mae and Freddie Mac had used leverage to take over $5 trillion in loan guarantees during this period and suffered incredible losses as a result of the subprime mortgage crisis. In fact, had the federal government not stepped in to bail them out, they would have become insolvent.
On September 6, 2008, the Federal Housing Finance Agency placed Fannie Mae and Freddie Mac in conservatorship and provided them with $190 billion in emergency funding. Because they were no longer shareholder-governed, they were delisted from the New York Stock Exchange.
Fannie Mae was also to blame for her role in bundling and selling CMOs, particularly because they were guaranteed by the US government. Rating agencies, such as Standard & Poor’s, Moody’s and Fitch, incorrectly assigned these subprime mortgage pools AAA ratings when they were, in fact, much riskier.
As a result, 76% of CMOs filled with subprime mortgages were downgraded to junk status in 2010, resulting in write-downs or losses amounting to more than half a trillion dollars.
Contagion effect leading to the global financial crisis
The collapse of financial markets in the United States had a contagion effect that spread to other countries, with many economists calling it a global financial crisis. The United States is often seen as a safe investment destination, and when stock and bond prices there fell in late 2008, nations with strong economic and financial ties to the United States suffered and saw their markets fall in sympathy. Many countries used the US dollar as their main source of international reserves, but then sought to diversify their reserves with other currencies.
How was the financial crisis of 2007-2008 resolved?
In September 2008, Congress approved the “bailout bill”, which provided $700 billion to add emergency liquidity to the markets. Through the Troubled Asset Relief Program (TARP) adopted in October 2008, the US Treasury added billions more to stabilize financial markets, including buying shares in banks. Additionally, through TARP, investment banks like Goldman Sachs and Morgan Stanley changed their charters and became commercial banks.
Between 2008 and 2014, the Federal Reserve cut interest rates to nearly 0%.
He also launched a series of quantitative easing measures that added more than $4 trillion to the financial system and thus encouraged banks to lend again, to each other and to consumers.
Many homeowners, struggling to avoid foreclosure, received home loans, and in 2011 President Barack Obama approved a program that would allow borrowers to refinance their loans even if they were “under water” or the value of their home was less than the amount that had to pay off their remaining mortgage.
To reform the financial sector and prevent future financial crises, Congress in 2010 passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Dodd-Frank limited future speculative transactions by banks. Additionally, he created the Consumer Financial Protection Bureau to protect consumers from new predatory lending practices.
In addition, rating agencies have been subject to stricter supervision and must now demonstrate greater transparency. For example, they are now only authorized to issue ratings on structured products, such as CMOs, insofar as they have obtained and published information on their underlying assets.
Is another financial crisis coming?
Luc Olinga of TheStreet.com thinks the current cryptocurrency crisis has undertones of Lehman Brothers everywhere.