How the 2008 Financial Crisis Shook the World

The 2008 financial crisis was a global economic disaster that had far-reaching consequences for millions of people. It was triggered by a collapse of the US housing market, which exposed the fragility and interconnectedness of the financial system. In this blog post, we will explore what caused the crisis, how it unfolded, and what measures were taken to prevent a repeat. In some ways there are similarities in a way how the things are unfolding to the current crisis that has followed Covid and Russia-Ukraine war. We have already seen CDS hitting new highs last year, multiple banks collapsing (including Credit Suisse that had a very rich history). Somehow the economies are still holding, but 2008 was a good lesson that we should keep in mind now as well.

The Origins of the Crisis

The roots of the crisis can be traced back to the late 1990s and early 2000s, when the US economy was booming and interest rates were low. This created a high demand for housing, which drove up prices and encouraged lenders to offer mortgages to borrowers with low incomes and poor credit histories. These mortgages, known as subprime mortgages, were often packaged into complex financial products called mortgage-backed securities (MBS), which were sold to institutional investors around the world. They were considered AAA securities due to diversification based on a large number of underlying credits. One of the oversights of the credit agencies was that all of those loans had a strong correlation, which could multiply the level of risk under certain risk scenarios. The MBS market grew rapidly, reaching a peak of $7.3 trillion in 2007.

However, the housing boom was unsustainable, and by 2006, the market began to cool down. Many borrowers found themselves unable to repay their loans or refinance their mortgages, leading to a wave of defaults and foreclosures. As a result, the value of MBS plummeted, causing huge losses for banks and investors who held them. Many of these MBS were also linked to other financial instruments, such as derivatives and credit default swaps, which amplified the risk and uncertainty in the system.

The Crisis Unfolds

The first signs of trouble emerged in 2007, when several large banks and hedge funds reported losses related to subprime mortgages. In August 2007, the interbank lending market froze, as banks became reluctant to lend to each other for fear of exposure to toxic assets. The Federal Reserve and other central banks intervened to provide liquidity and lower interest rates, but this was not enough to restore confidence.

In March 2008, Bear Stearns, one of the largest investment banks in the US, faced a liquidity crisis and was acquired by JPMorgan Chase with the help of the Federal Reserve. This was followed by the collapse of Lehman Brothers, another major investment bank, on September 15, 2008. Lehman Brothers filed for bankruptcy after failing to find a buyer or secure government assistance. This was the largest bankruptcy in US history (USD 691 billion in assets) and sent shockwaves through the global financial system. It is the largest even considering the Silicon Valley bank’s bankruptcy in March 2023 having USD 209 billion in assets.

The failure of Lehman Brothers triggered a panic among investors, who rushed to withdraw their money from banks and money market funds. The stock markets plunged, credit markets seized up, and many financial institutions faced insolvency or illiquidity. Some of the most prominent casualties included AIG, Merrill Lynch, Washington Mutual, Wachovia, Fannie Mae, Freddie Mac, and several European banks.

The Government Response

The US government responded to the crisis with unprecedented interventions to stabilize the financial system and stimulate the economy. Some of the key measures included:

• The Troubled Asset Relief Program (TARP), which authorized the Treasury Department to purchase or insure up to $700 billion of troubled assets from banks and other financial institutions.
• The Emergency Economic Stabilization Act of 2008 (EESA), which established oversight mechanisms and conditions for TARP funds, such as executive compensation limits and equity stakes for taxpayers.
• The American Recovery and Reinvestment Act of 2009 (ARRA), which provided $787 billion of fiscal stimulus through tax cuts, spending programs, and infrastructure projects.
• The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), which introduced sweeping reforms to regulate the financial sector, such as higher capital requirements, stress tests, consumer protection agencies, and resolution authority for failing firms.

In addition to these domestic actions, the US also coordinated with other countries and international organizations to address the global implications of the crisis. For instance,

• The Group of Twenty (G20) leaders met several times to agree on common principles and actions for restoring growth and stability.
• The International Monetary Fund (IMF) expanded its lending capacity and provided emergency loans to countries facing balance-of-payments crises.
• The Basel Committee on Banking Supervision (BCBS) revised its standards for bank capital adequacy and liquidity risk management.

The Aftermath of the Crisis

The 2008 financial crisis had a profound impact on the world economy and society. It triggered a deep recession that lasted from December 2007 to June 2009 in the US and longer in some other countries. The recession resulted in massive job losses, income declines, poverty increases, wealth destructions, business failures, and social unrest.

The recovery from the recession was slow and uneven, as many countries faced fiscal and debt challenges, structural imbalances, and political uncertainties. The crisis also exposed the weaknesses and vulnerabilities of the global financial system and the need for better regulation, supervision, and coordination. The crisis also raised questions about the role and responsibility of the financial sector in serving the real economy and society.

The 2008 financial crisis was a watershed moment in history that changed the course of the world. It taught us valuable lessons about the dangers of excessive risk-taking, the importance of transparency and accountability, and the necessity of cooperation and solidarity. It also reminded us of the human costs and consequences of financial instability and economic hardship. As we look ahead to the future, we should not forget the lessons of the past and strive to build a more resilient, inclusive, and sustainable financial system.

Please note, none of the information on this blog represents the opinion of my employer and all information does not represent a financial advice.