The global financial markets experienced a significant reduction in liquidity during the 2007–2008 financial crisis, which was triggered by the collapse of the US housing market. The global financial system was in danger of collapsing; numerous major commercial and investment banks, mortgage lenders, insurance providers, and savings and loan associations failed or were on the verge of failing; and the Great Recession (2007–09), the worst economic downturn since the Great Depression (1929–c. 1939), was sparked by it.
REASONS BEHIND THE CRISIS
Economists disagree about the specific causes of the financial crisis, although they generally agree on the variables that contributed (though experts differ on the relative importance of these issues).
First, the US central bank, the Federal Reserve (Fed), lowered the federal funds rate the interest rate banks charge one another for overnight loans of federal funds, or balances held at a Federal Reserve bank eleven times between May 2000 and December 2001, from 6.5 percent to 1.75 percent, in anticipation of a mild recession that was expected to start in 2001. The notable decline allowed banks to offer credit to consumers at a prime rate the interest rate they charge to their "prime," or low-risk, clients, usually three percentage points higher than the federal funds rate) and enticed them to extend credit, even to high-risk or "subprime" borrowers, albeit at interest rates that were higher (see subprime lending). Customers bought durable things like cars, appliances, and houses in particular by taking advantage of the low-cost borrowing. As a result, a "housing bubble" a sharp rise in property values to levels considerably above their intrinsic or basic value was created in the late 1990s as a result of excessive speculation.
Second, due to changes in banking regulations that started in the 1980s, banks were allowed to offer mortgage loans with balloon payments unusual large payments that are due at or close to the end of a loan period and adjustable interest rates, rates that are initially fixed at relatively low levels and then fluctuate, usually in line with the federal funds rate. These loans were made available to subprime customers by banks. Subprime borrowers may shield themselves from excessive mortgage payments as long as home prices grew by refinancing, taking out loans against the appreciation of their properties, or selling their houses for a profit and paying off their debts. Banks may seize the property in the event of default and sell it for a price higher than the original.
As a result, a lot of banks actively promoted subprime loans to clients with low credit scores or minimal assets, even though they knew these borrowers couldn't afford the payments and frequently misled them about the risks. Consequently, during the late 1990s to 2004–07, the percentage of subprime mortgages among all house loans rose from roughly 2.5 percent to over 15 percent annually.
Third, the widespread practice of securitization in which banks packaged hundreds or even thousands of subprime mortgages and other, less hazardous types of consumer debt and sold them (or portions of them) to other banks and investors, such as hedge funds and pension funds in the capital markets as securities (bonds) contributed to the expansion of subprime lending. Mortgage-backed securities, or MBSs, were bonds made mostly of mortgages that gave their buyers the right to a portion of the interest and principal payments on the underlying loans. While buying MBSs was seen as a smart way for banks and investors to diversify their portfolios, selling subprime mortgages as MBSs was seen to be a good way for banks to enhance their liquidity and decrease their exposure to problematic loans. As home prices continued their meteoric rise through the early 2000s, MBSs became widely popular, and their prices in capital markets increased accordingly.
Fourth, the Glass-Steagall Act (1933), which had been in place since the Great Depression, was partially repealed in 1999. This allowed banks, insurance companies, and securities firms to enter and merge with each other's markets, leading to the creation of banks that were considered "too big to fail"—that is, so large that the failure of one would pose a threat to the stability of the entire financial system. Furthermore, banks were incentivized to invest even more in MBSs in 2004 when the Securities and Exchange Commission (SEC) relaxed the net-capital requirement, which measures the ratio of capital, or assets, to debt, or liabilities, that banks must maintain as a bulwark against insolvency. Banks made huge profits as a result of the SEC's judgment, but their portfolios were also exposed to a great deal of risk because the MBSs' asset value was predicated on the continuation of the housing bubble.
Ultimately, the lengthy stretch of global economic expansion and stability that started in the middle to late 1980s and is now referred to as the "Great Moderation" persuaded a number of American economists, government officials, and banking executives that the era of excessive economic volatility was over. This brings us to our final point. In addition to an ideological environment that emphasized deregulation and the capacity of financial firms to self-police, this self-assured mindset caused nearly all of them to ignore or downplay obvious indicators of an approaching crisis and, in the case of bankers, to carry on with reckless lending, borrowing, and securitization practices.
CRUCIAL MOMENTS IN THE CRISIS
A number of events starting in 2004 foreshadowed the impending crisis, even though very few economists foresaw its magnitude. The Federal Reserve increased the federal funds rate from 1.25 to 5.25 percent over a two-year period (June 2004 to June 2006), which unavoidably led to an increase in subprime borrowers defaulting on their adjustable-rate mortgages (ARMs). In 2005, home sales and prices started to decline, partly due to the rate hike and partly because the housing market had reached a saturation point. Due to a lack of purchasers and the fact that many mortgage holders were now "underwater" that is, paying more on their loans than their homes were worth many subprime mortgage holders were unable to save themselves through borrowing, refinancing, or selling their properties occurrence that became more widespread as the situation deepened. MBSs based on subprime mortgages lost value as more and more subprime borrowers defaulted and as home prices declined, which had disastrous effects on the portfolios of numerous banks and financial institutions. Though most experts insisted that the problems were not as serious as they appeared and that damage to financial markets could be contained, it was quickly apparent that the trouble in the United States would have global implications because MBSs generated from the U.S. housing market had also been bought and sold in other countries (notably in western Europe), many of which had experienced their own housing bubbles.
By 2007, a number of banks, hedge funds, and mortgage lenders had suffered significant losses as a result of the sharp decline in MBS values. A few large, well-known companies were even forced to liquidate hedge funds that had invested in MBSs, file for bankruptcy, seek loans from the government, or look for mergers with healthier businesses. Even the companies that were not immediately in danger suffered billion-dollar losses since the MBSs in which they had made such large investments were now downgraded by credit rating agencies, turning them into assets that were practically worthless, or "toxic." Because the banks that paid for these agencies' services also paid for the debt instruments these agencies assessed, these agencies were later accused of having a serious conflict of interest. At first, that financial connection provided motivation for critics claim that agencies have given some MBSs misleadingly high ratings.) One of the biggest subprime lenders, New Century Financial Corp., declared bankruptcy in April 2007, and several other subprime lenders quickly followed suit. Banks ceased lending to subprime customers since they could no longer finance subprime loans through the sale of MBSs. This led to a further decrease in property values and sales, as well as a disincentive to buy a home even for those with good credit ratings. The biggest bank in France, BNP Paribas, revealed billion-dollar losses in August, while American Home Mortgage Investment Corp., a sizable American company, filed for bankruptcy.
It was challenging to assess the strength of bank portfolios containing MBSs as assets, even for the bank that owned them, in part because it was challenging to ascertain the amount of subprime debt in any given MBS (as MBSs were typically sold in pieces, mixed with other debt, and resold in capital markets as new securities in a process that could continue indefinitely). As a result, banks started to question one another's stability, which set off a federal funds market freeze that may have catastrophic effects. In order to give banks additional liquidity and lower the federal funds rate which had momentarily risen over the Federal Reserve's objective of 5.25 percent the Fed started buying federal funds (in the form of government securities) at the beginning of August.
Similar open-market operations were carried out by central banks in other regions of the world, most notably in the European Union, Australia, Canada, and Japan. The Federal Reserve was forced to directly lower the federal funds rate three times between September and December, to 4.25 percent, as a result of the Fed's action eventually failing to stabilize the U.S. financial system. Around the same time, Northern Rock, the UK's fifth-largest mortgage lender, ran out of liquid assets and made a loan appeal to the Bank of England. The first bank runs in the UK in 150 years occurred as a result of depositor panic brought on by news of the bailout. In February 2008, the British government nationalized Northern Rock.
In January 2008, the US financial crisis got worse when Bank of America decided to buy Countrywide Financial, which used to be the top mortgage lender in the nation, for under $4 billion in stock a small portion of the company's previous valuation. After depleting its liquid assets, the esteemed Wall Street investment firm Bear Stearns was acquired by JPMorgan Chase in March a company that had also suffered billion-dollar losses. Bear Stearns's bankruptcy threatened other big banks it had borrowed from, so the Fed helped to smooth the sale by taking on $30 billion of the company's high-risk assets. In the meantime, the federal funds rate saw more cuts by the Fed, falling from 4.25 percent in early January to just 2 percent in April (the rate was decreased again) later in the year, to 1 percent by the end of October and to effectively 0 percent in December). Although the rate cuts and other interventions during the first half of the year had some stabilizing effect, they did not end the crisis; indeed, the worst was yet to come.
The federally authorized companies that controlled the secondary mortgage market the market for purchasing and disposing of mortgage loans Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation) were in major problems by the summer of 2008. By purchasing mortgage loans and either retaining them or selling them with a guarantee of main and interest payments to other banks and investors, both entities had been set up to give liquidity to mortgage lenders. The ability to sell mortgage loans as MBSs was granted to both. Fannie Mae and Freddie Mac's portfolios saw a spike in subprime mortgages as a percentage of all home loans in the early 2000s, in part due to changes in policy intended to encourage low-income and minority populations to purchase homes. 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.
The largest bankruptcy in American history was filed later that month by the 168-year-old financial bank Lehman Brothers, which had $639 billion in assets. Its demise sparked long-lasting instability in global financial markets, seriously damaged the loan portfolios of the banks that had provided it with funds, and increased bank mistrust, which prompted banks to further curtail interbank lending. The Treasury Department declined to get involved, citing "moral hazard" that is, the possibility that saving Lehman would inspire other banks to act recklessly in the future, believing that government assistance would only be a last resort despite the fact that Lehman had attempted to find partners or buyers and had hoped for government assistance to facilitate a deal. But the Fed decided to lend American International just one day later the country’s largest insurance company, $85 billion to cover losses related to its sale of credit default swaps (CDSs), a financial contract that protects holders of various debt instruments, including MBSs, in the event of default on the underlying loans. Unlike Lehman, AIG was deemed “too big to fail,” because its collapse would likely cause the failure of many banks that had bought CDSs to insure their purchases of MBSs, which were now worthless. Less than two weeks after Lehman’s demise, Washington Mutual, the country’s largest savings and loan, was seized by federal regulators and sold the next day to JPMorgan Chase.
By now, Treasury Department officials and economists alike agreed that a more robust reaction from the government was required to save the financial system from completely collapsing and to avoid long-term harm to the American economy. The Emergency Economic Stabilization Act (EESA), which was proposed by the George W. Bush administration in September, would create a Troubled Asset Relief Program (TARP) and give Henry Paulson, the Secretary of the Treasury, the authority to buy up to $700 billion worth of mortgage-backed securities (MBSs) and other "troubled assets" from American banks. The bill was changed and approved by the Senate after the House of Representatives initially rejected it because most of its members thought it was an unfair bailout of Wall Street banks. As the nation's financial system continued to deteriorate, several representatives changed their minds, and the House passed the legislation on October 3, 2008; President Bush signed it the same day.
But it quickly became clear that the government's acquisition of MBSs would not supply enough liquidity in time to stop a number of further banks from failing. As a result, Paulson was given permission to utilize up to $250 billion in TARP funds to buy preferred stock in financially ailing companies, allowing the federal government to acquire a stake in more than 200 banks by year's end. Following that, the Fed implemented a number of unprecedented quantitative-easing (QE) programs under a number of overlapping but distinct names. The goal of these programs was to deploy money that the Fed had generated to increase liquidity in the capital markets and, as a result, boost economic growth. Other nations' central banks have made similar interventions. Among the Fed's actions was the acquisition of long-term US Treasury bonds. By the time the QE programs were officially ended in 2014, the Fed had by such means pumped more than $4 trillion into the U.S. economy. Despite warnings from some economists that the creation of trillions of dollars of new money would lead to hyperinflation, the U.S. inflation rate remained below the Fed’s target rate of 2 percent through the end of 2014.
Most people now think that the Federal Reserve's actions to safeguard the American financial system and promote economic expansion prevented a global financial meltdown. The American Recovery and Reinvestment Act, a $787 billion stimulus and relief program proposed by the Barack Obama administration and approved by Congress in February 2009, also had a role in helping the United States recover from the worst effects of the Great Recession. After almost two years of severe recession, the financial markets had started to recover by the middle of that year, and the economy had started to expand. The Wall Street Reform and Consumer Protection Act, also known as the Dodd-Frank Act, was passed by Congress in 2010 and established banking regulations to avert another financial disaster Among other things, the Consumer Financial Protection Bureau was tasked with overseeing subprime mortgage loans and other types of consumer credit. But in 2017, a Republican-controlled Congress and the Trump administration, who were both opposed to the law's goals, essentially repealed or neutralized many of the Dodd-Frank Act's features.