2008 Financial Crisis: Subprime Mortgages, Lehman and Recession

The 2008 financial crisis, also called the global financial crisis, was the most severe breakdown of the world’s financial system since the Great Depression. It began in 2007 with losses on risky American home loans and reached a peak in September 2008, when the investment bank Lehman Brothers collapsed and panic spread through banks worldwide. The crisis triggered the Great Recession, cost millions of people their jobs and homes, and reshaped economic policy and politics for more than a decade.

Background: the housing bubble

In the early 2000s, low interest rates, easy credit and a belief that house prices could only rise fuelled a boom in the US housing market. Between 2000 and 2006 average American house prices roughly doubled in nominal terms, according to the widely used Case–Shiller index.

Lenders increasingly offered subprime mortgages, loans to borrowers with weak credit histories. Many of these loans had low “teaser” interest rates that reset sharply higher after two or three years, and some required little or no proof of income. Borrowers and lenders alike assumed that rising prices would allow homes to be refinanced or sold at a profit.

The mortgages did not stay with the banks that made them. Wall Street firms bundled thousands of loans into mortgage-backed securities and more complex products called collateralised debt obligations (CDOs). Credit rating agencies gave many of these products top AAA ratings, and they were sold to banks, pension funds and investors across the world, especially in Europe.

Leverage and the shadow banking system

The danger was magnified by leverage, meaning the use of borrowed money. Investment banks such as Lehman Brothers and Bear Stearns held assets worth 30 or more times their own capital, so a small fall in asset values could wipe out their equity.

Much of this borrowing was short-term, through overnight lending markets and commercial paper, in what became known as the “shadow banking system”. Unlike ordinary bank deposits, this funding had no government guarantee and could vanish almost overnight. Insurance-style contracts called credit default swaps, sold in huge volumes by the insurer AIG, linked the fate of many firms together.

The crisis unfolds, 2007–2008

US house prices peaked in 2006 and began to fall. Defaults on subprime loans rose quickly, and in early 2007 dozens of subprime lenders went bankrupt, including New Century Financial in April.

On 9 August 2007 the French bank BNP Paribas froze three investment funds because it could not value their US mortgage assets. Banks suddenly stopped lending to each other, and the European Central Bank and the US Federal Reserve injected emergency money into markets. Many historians of the crisis treat this day as its true beginning.

In September 2007 the British mortgage lender Northern Rock, which relied on short-term market funding, asked the Bank of England for support. Queues of depositors formed outside its branches, the first major run on a British bank in more than a century. It was nationalised in February 2008.

Bear Stearns and the summer of 2008

In March 2008 the investment bank Bear Stearns ran out of cash. To prevent a disorderly failure, the Federal Reserve helped arrange its sale to JPMorgan Chase, providing a loan backed by about 30 billion dollars of Bear’s assets.

By the summer, attention turned to Fannie Mae and Freddie Mac, the two giant government-sponsored companies that guaranteed or owned roughly half of all US mortgages. On 7 September 2008 the US government placed both into conservatorship, effectively taking them over.

September 2008: Lehman and the panic

Lehman Brothers, the fourth-largest US investment bank, had large losses on real estate and mortgage securities. Over the weekend of 13–14 September 2008, Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke and New York Fed President Timothy Geithner tried to arrange a private rescue. Bank of America chose instead to buy Merrill Lynch, and the British bank Barclays could not obtain approval to take over Lehman in time.

On 15 September 2008 Lehman Brothers filed for bankruptcy, with assets of about 639 billion dollars, the largest bankruptcy in US history. Officials later argued that they lacked the legal power to save it; critics argued that letting it fail turned a serious crisis into a global panic.

The shock spread immediately. On 16 September the Federal Reserve lent AIG 85 billion dollars because its failure would have caused losses across the financial system. The same day, a large money market fund, the Reserve Primary Fund, “broke the buck” after losses on Lehman debt, triggering withdrawals from funds that millions of Americans had treated as safe as cash. Credit markets froze, and companies struggled to borrow even for day-to-day needs.

Later that month, Washington Mutual became the largest bank failure in US history, and Wachovia was sold under pressure. Goldman Sachs and Morgan Stanley converted into bank holding companies to gain access to Federal Reserve support.

Bailouts and rescues

On 29 September 2008 the US House of Representatives initially rejected a bank rescue bill, and the Dow Jones index fell by about 778 points, its largest one-day point fall up to that time. A revised bill, creating the 700-billion-dollar Troubled Asset Relief Program (TARP), was signed into law on 3 October.

Europe was hit just as hard. Governments rescued or nationalised banks including Fortis, Dexia, Hypo Real Estate and Royal Bank of Scotland. In October 2008 the British government under Prime Minister Gordon Brown announced a plan to recapitalise its banks with public money, an approach that other countries, including the United States, soon followed. Iceland’s three main banks collapsed within days, and the country turned to the International Monetary Fund.

Central banks cut interest rates sharply, including a coordinated cut on 8 October 2008, and later began large-scale purchases of bonds known as quantitative easing. In November 2008 leaders of the G20 group of major economies met in Washington for their first summit, and at the London summit in April 2009 they pledged large additional resources for the IMF and other institutions.

The Great Recession

The financial crisis turned into the worst global downturn since the 1930s. In the United States the recession officially ran from December 2007 to June 2009. Unemployment rose from under 5 percent to a peak of 10 percent in October 2009, and roughly 8–9 million jobs were lost. Millions of families lost their homes through foreclosure.

World output shrank in 2009 for the first time in the post-war era, and world trade fell steeply. Governments responded with stimulus programmes, such as the American Recovery and Reinvestment Act of February 2009, worth about 787 billion dollars, and China’s stimulus of about 4 trillion yuan. The US government also rescued General Motors and Chrysler.

In Europe, the crisis exposed weaknesses in public finances and in the design of the single currency. From 2009–2010 it developed into the eurozone debt crisis, which hit Greece, Ireland, Portugal, Spain and Cyprus especially hard.

Reforms

In July 2010 the United States passed the Dodd–Frank Wall Street Reform and Consumer Protection Act. It created the Consumer Financial Protection Bureau, set up a council to monitor risks to the whole financial system, required stress tests for large banks and pushed most derivatives trading onto regulated platforms.

Internationally, the Basel Committee on Banking Supervision agreed the Basel III rules from 2010, requiring banks to hold more and higher-quality capital and more liquid assets. The European Union created new supervisory authorities and later a banking union with the European Central Bank as the main supervisor of large eurozone banks.

Legacy and debate

Economists still debate the relative weight of the causes: loose monetary policy, weak regulation, flawed incentives in mortgage lending, the failures of rating agencies, global imbalances in savings, and the sheer complexity of financial products. The official US Financial Crisis Inquiry Commission concluded in 2011 that the crisis was avoidable, though some of its members dissented.

The crisis invites comparison with the Wall Street Crash of 1929 and the Great Depression. Rapid action by central banks and governments is widely credited with preventing a collapse on that scale, but the recovery was slow, and the bailouts of banks while ordinary people lost jobs and homes produced deep public anger. That anger fed movements such as Occupy Wall Street and the Tea Party and shaped politics across Europe and North America in the following decade.

By the numbers

Timeline

• 2006, mid-year: US house prices peak and start to fall.
• 2007, 9 August: BNP Paribas freezes three funds; central banks inject emergency liquidity.
• 2007, 14 September: Northern Rock receives emergency Bank of England support; a bank run follows.
• 2008, 16 March: JPMorgan Chase agrees to buy Bear Stearns with Federal Reserve backing.
• 2008, 7 September: Fannie Mae and Freddie Mac are placed into government conservatorship.
• 2008, 15 September: Lehman Brothers files for bankruptcy; Merrill Lynch agrees a sale to Bank of America.
• 2008, 16 September: The Federal Reserve rescues AIG with an 85-billion-dollar loan.
• 2008, 3 October: TARP becomes law in the United States.
• 2009, 9 March: US stock markets hit their crisis low.
• 2010, 21 July: The Dodd–Frank Act is signed into law.

Why it matters

The 2008 financial crisis showed how a housing bust in one country could bring the global economy to the edge of collapse through interconnected banks and complex debts. Its bailouts, recession and reforms still shape banking rules, central bank policy and public trust in financial institutions today.