In 2008, the world witnessed the biggest financial crisis since the Great Depression.  Although this crisis started in the financial markets, it soon spread to real-world sectors and caused a great deal of pain for ordinary citizens in the US and Europe. To avoid similar crashes in the future, we must first understand the foundations of the most recent crash.

The roots

During the Clinton administration in the, the US economy experienced 8% GDP growth for multiple years. A growth of this magnitude, for an economy as big as the US economy, was applauded by the economists around the world. During this period, the US economy was expanding in all fields; each sector was developing new areas of investment. Investment banks were especially aggressive in seeking new investment opportunities, hoping to get a larger share of the growing economy. Unfortunately, in their haste, they did not perform proper risk analyses on these new behaviors. Some of new forms of investment had high profitability, but they also carried serious amounts of risk. However, nobody was questioning the high risk aspects of these investments. One of the fastest growing sectors was the housing market. House prices were booming in conjunction with the high employment levels and wages. As a result, financial institutions were underwriting mortgage loans at record levels. Mortgage loans are illiquid items on financial institutions’ balance sheets. As such, financial institutions believed that they were not adequately utilizing these mortgage loans. In response, financial firms invented the “mortgage backed securities” by “bundling” mortgage loans.

This new investment vehicle provided investors with bonds of various levels of leverage and risk preferences by bundling the mortgage loans and putting a structure around them. These bundled mortgage-backed securities were well received by the credit agencies; many mortgage bonds were rewarded with AAA ratings (the highest possible rating) even though many of the individual bonds making up the bundles were poorly rated. As a result, with the high demand for these investment vehicles, financial institutions were able to convert illiquid mortgage loans into highly liquid and profitable bonds.

False applications in the mortgage market

One of the common mistakes Wall Street makes is to take a brilliant idea, put it into application, and then generate asset bubbles by over applying the great idea. Unfortunately, bundled mortgage products caused one of the biggest bubbles of recent times. In order to satisfy the high demand for mortgage-backed securities from investment banks, financial institutions greatly increased the amount of mortgage loans they underwrote. As a result, many individuals who would not otherwise be able to qualify for a mortgage loan were granted loans. This trend resulted in a bubble in the housing and mortgage sectors, and the volume of mortgage-backed securities increased to $2.1 trillion. Utilizing their high leverage levels, banks ended up issuing mortgage backed securities in excess of existing mortgage loans.

As a result, the sub-prime mortgage market was overloaded with individuals who had low credit scores. However, at this time the U.S. economy was booming and house prices kept rising. During this period, the Federal Reserve failed to recognize the increasing threat from the mortgage sector. The Fed did recognize the abnormal growth in the U.S. economy and was trying to take preventive measures for a softer landing for the anticipated recession thereafter. However, the Fed did not seem to identify the heart of the problem. The Fed believed that if a home owner defaulted on his or her mortgage, he or she would be able to sell their house at a higher price and move on, given that housing prices kept rising. Therefore, mortgage defaults were not a threat to the economy.

This approach alone indicates that the Fed failed to perform the necessary analyses to identify the threat coming from the housing market. Unfortunately, after peaking in 2006, housing prices started to fall in 2007, and this triggered the financial crisis that would shock financial markets around the globe. In the blink of an eye, the upward trend in the global economy was dramatically reversed. The people who normally should not have been granted mortgage loans started to default on their loans and were thus forced to sell their houses far below the prices they purchased them at. These sums were not sufficient to cover the original amount of their loans. And many home owners failed to sell their houses, which were therefore sold in foreclosures by the banks at even lower prices. This pushed housing prices even lower. With the increasing number of foreclosures, the U.S. economy faced a severe problem. Mortgage loans were the foundation of mortgage-backed securities. Given the high leverage used in structuring the mortgage-backed securities, the amount of existing mortgage-backed securities that were under stress was in excess of the existing mortgage loans. The high level of defaults on mortgage loans resulted in a huge drop in mortgage-bond valuation. This turmoil in the mortgage market put stress on all the investment firms who had mortgage bonds in their portfolios. Credit rating agencies, traditionally, were able to recognize their incorrect ratings; in 2007, these agencies downgraded many mortgage loans which were originally granted high ratings.

The crisis spreads across financial markets

The downgrading of the mortgage bundles was a wakeup call for other actors in the financial markets, and a financial panic began spreading to many other markets. The summer of 2007 witnessed a high volume of activity compared to the previous summers. In a couple of months, spreads on credit default swaps were doubled. The crisis first hit the mortgage underwriters and many mortgage companies declared bankruptcy. Countrywide Home Loans was saved by being acquired by Bank of America.

At this juncture, financial institutions pressured the Fed to decrease the interest rates to boost the economy. However, the Fed had not grasped the severity of the situation. The Fed did not want to decrease the rates, as it was hoping to avoid the possible depreciation of the U.S. Dollar and a potential increase in inflation. The Fed was finally able to start decreasing the rates in September 2007, which turned out to be too late to stop the impending collapse.

After mortgage companies, the crisis spread to the banks. The distrust in mortgage bonds was spreading to all sectors of the global economy. As a result, banks – especially investment banks – were suddenly in distress, as the high leverage investments on their balance sheets rapidly lost a substantial amount of their value. The Fed finally recognized the severity of the problem and started taking unprecedented measures to save many of these financial institutions.

However, some investment banks had too many troubled assets on their balance sheets. First, the smallest of the “big five” investment banks, Bear Sterns, was almost bankrupted in March 2008. This resulted in significant drops in the U.S. stock market. JP Morgan Chase saved Bear Sterns by acquiring it. This gave temporary relief to the financial markets.

During this period, the Fed was still claiming that the financial crisis would not spread to other sectors of the economy. However, there was a substantial shift in expectations. The troubled finance companies undertook huge layoffs in order to save themselves. Those who had lost their jobs started to lose their homes, as well. And soon, not only the sub-prime mortgages, but also all other types of mortgages, started defaulting. This accelerated the price drops in mortgage bonds even more, causing further trouble for finance companies. On the other hand, the new houses coming onto the market, coupled with foreclosures, increased the excess supply in the housing market, which drove house prices even lower. As a result of large layoffs at the financial companies, the spending by the laid off employees decreased, which lowered the demand for the firms’ products, which in result caused even more problems for the troubled firms, and thus resulted in even more layoffs. The economy was in a disastrous cycle, and the financial crisis was now ready to spread to the “real” sector.

Further compounding problems at this point, crude oil prices went as high as $145 per barrel, which increased the cost of goods, causing even more problems for the greater economy. Also, the credit crunch was at its peak.  Troubled banks were not lending out to the financial firms, and it was very difficult for the firms to find a way out from the dire situation in which they found themselves. 2008 was a brutal year for the investment banks. Merrill Lynch was saved from going bankrupt when they were acquired by Bank of America in an operation orchestrated by the U.S. Treasury. However, the same government officials let Lehman Brothers go bankrupt to set an example for the financial institutions and to signal to the market that they would not save every troubled financial institution. Whatever the symbolic power of the gesture, the real-world result was devastating. Following the largest bankruptcy in U.S. history ($639 billion) , panic spread all over the U.S. financial markets. As a result, many financial and economic indicators dipped. Following Lehman Brothers, 54 more U.S. companies declared bankruptcy. Unemployment passed 10%. The Federal Reserve decreased its funds rate to zero percent and transferred billions of dollars to financial institutions. The invoice to save AIG alone was for $85 billion.

The chaos in the U.S. financial markets continued for almost 7 months, with the markets finally hitting bottom in March 2009. The remaining investment banks on Wall Street, Goldman Sachs and Morgan Stanley, converted themselves to holding banks in order to survive the crisis. This technically ended the investment bank era on Wall Street.

Macroeconomic troubles in the U.S. economy

The stock market started to recover following the market bottom in March 2009. Since then, the major stock indices in the New York Stock exchange have gained over 100%. This recovery is a result of unprecedented support from the Federal Reserve and the U.S. Treasury. However, as a result, the U.S. economy had a record budget deficit of $1.4 trillion in 2009 and a deficit of $1.3 trillion in 2010. Today, though unemployment is below 5%, a stubbornly high percentage of workers have simply taken themselves out of the job market. The Fed’s funds rate is still at zero percent. Though the U.S. had a financial crisis in 2007-2009, today the U.S. faces macroeconomic issues.

The financial crisis in Europe

The European Union followed a similar path during the financial crisis. Since the financial markets are interconnected, the crisis easily spread to markets in Europe. However, U.S. officials were more determined to resolve the economic and financial issues by taking unprecedented measures, whereas officials in the European Union were more conservative. The financial crisis forced the hidden problems in European Union to the surface. The economic problems in Greece especially showed the lack of financial and economic strength in some European countries. In March 2012, Greece had to restructure its sovereign debt. This restructuring caused a $3 billion default in sovereign credit default swap contracts. In addition to Greece, Portugal and Italy have also experienced severe economic problems. Even Spain and France have showed signs of instability. In summary, compared to the U.S., the European Union has much deeper problems. In the coming years, the Union might face real challenges that threaten its very existence, as recently indicated by the Brexit phenomenon.

Conclusion

The recent financial crisis caused some fundamental changes to the global economy. The world’s largest stock exchange, the New York Stock Exchange, experienced its largest crash since the Great Depression. The impact of the crisis was quite painful for ordinary people in the U.S. and Europe.

Ali Fakih is a researcher specialized in financial markets, investments, and market microstructure.

References

• Brunnermeier, Marcus K., Deciphering the Liquidity and Credit Crunch 2007-2008, Journal of Economic Perspectives, Volume 23, Number 1, Winter 2009, Pages 77–100
• Federal Housing Finance Agency, Housing Market Data, http://www.fhfa.gov/
• Markit, CreditEx, http://www.creditfixings.com/information/affiliations/fixings.html
• U.S. Department of Labor, Bureau of Labor Statistics, http://www.bls.gov/ces/
• Wikipedia, Bankruptcy of Lehman Brothers, http://en.wikipedia.org/wiki/Bankruptcy_of_Lehman_Brothers
• Federal Housing Finance Agency