2007–2008 Financial Crisis Overview
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2007–2008 Financial Crisis Overview

10 Min.

The financial crisis of 2007-2008 unfolded slowly. It all started in early 2006 when home prices began to decline. By early 2007, subprime lenders had started filing for bankruptcy. In June of that year, two large hedge funds failed due to their investments in subprime loans. As a result, panic set in, and the global lending system froze in August 2007, caused by losses from subprime loan investments. The crisis peaked in September 2008 when Lehman Brothers (the fourth-largest investment bank in the United States of that time) collapsed. This led to financial institutions being left with trillions of dollars of almost worthless subprime mortgage investments once the bubble burst.

Basics

In the lead-up to the summer of 2007, international financial markets began displaying ominous alerts, signaling that a long-anticipated reckoning was finally on the horizon after years of excessive reliance on inexpensive credit. This premonition was substantiated by several alarming occurrences: the demise of two Bear Stearns hedge funds, BNP Paribas issuing cautionary notices to investors regarding potential withdrawal limitations on three of its funds, and the imminent plea for emergency financial assistance by the British bank, Northern Rock, to the Bank of England.

However, despite these forewarnings, a meager number of investors harbored the foresight to anticipate the forthcoming catastrophe, which ultimately materialized as the most severe financial crisis in nearly eighty years. This calamity, now etched in history, would shake the foundations of the global financial system, crippling even the mightiest of Wall Street institutions and initiating what would later be known as the Great Recession. This catastrophic financial and economic collapse exacted a hefty toll on the lives of countless ordinary individuals, depriving them of their livelihoods, life savings, homes, or, in some instances, all three.

Planting the Roots of the Crisis

The origins of the financial crisis can be traced back to an era marked by historically low interest rates and lenient lending standards, which precipitated a housing price surge in the United States and worldwide. This story began with noble intentions. In response to the dot-com bubble burst, a string of corporate accounting scandals, and the tragic events of September 11, the Federal Reserve embarked on a mission. In May 2000, they initiated a descent in the federal funds rate, driving it down from 6.5% to a mere 1% by June 2003. Their objective was to invigorate the economy by ensuring the availability of capital to businesses and consumers at exceptionally favorable terms.

Consequently, this initiative triggered an upward trajectory in real estate values as borrowers capitalized on the alluring prospect of securing mortgages at remarkably low-interest rates. Astonishingly, even those with unfavorable credit histories, the subprime borrowers, found themselves capable of realizing the dream of homeownership.

The financial institutions, in turn, seized the opportunity to offload these loans onto Wall Street giants, who artfully bundled them into ostensibly low-risk financial instruments, such as mortgage-backed securities and collateralized debt obligations (CDOs). As a result, a thriving secondary market emerged for creating and distributing subprime loans.

Further stoking the appetite for risk within the banking sector, the Securities and Exchange Commission (SEC) introduced a significant shift in October 2004 by easing the net capital requirements for five investment banking behemoths: Goldman Sachs (NYSE: GS), Merrill Lynch (NYSE: MER), Lehman Brothers, Bear Stearns, and Morgan Stanley (NYSE: MS). This regulatory modification allowed them to amplify their initial investments by up to 30 or even 40 times.

Early Indications of Turbulence

Inevitably, the trajectory of interest rates shifted upwards while the saturation point in homeownership was reached. The Federal Reserve initiated a sequence of rate hikes in June 2004, culminating in the federal funds rate resting at 5.25% by August 2007, where it remained for two years. The initial harbingers of distress became apparent. By 2004, US homeownership had surged to its zenith, reaching 69.2%. However, the early throes of 2006 witnessed a decline in home prices.

This predicament inflicted substantial hardship upon countless Americans. The appraised values of their homes plummeted below their purchase prices, rendering them incapable of selling without incurring debts to their lenders. Those holding adjustable-rate mortgages found themselves grappling with rising costs, even as the value of their homes spiraled downwards. The most vulnerable segment, the subprime borrowers, found themselves trapped by mortgages they had never been able to afford from the outset.

According to Reuters news service, subprime mortgage giant New Century Financial extended loans approaching $60 billion in 2006. The year 2007, however, ushered in the company's declaration of bankruptcy protection.

As the year progressed, one subprime lender after another succumbed to financial turmoil. February and March bore witness to the demise of over 25 subprime lenders. In April, New Century Financial, a specialist in subprime lending, declared bankruptcy and reduced its workforce by half.

By June, Bear Stearns imposed restrictions on redemptions for two of its hedge funds, prompting Merrill Lynch to seize $800 million worth of assets from these funds. Nonetheless, these episodes paled compared to the tumultuous events ahead in the ensuing months.

August 2007: The Onset of a Financial Chain Reaction

As August 2007 unfolded, a stark reality took hold: the financial markets could not resolve the subprime crisis alone, and its repercussions rippled far beyond US borders. The vital interbank market, responsible for the fluidity of global capital, ground to a complete halt, primarily fueled by the specter of uncertainty. Northern Rock was compelled to seek emergency funding from the Bank of England, grappling with a liquidity crisis. In October 2007, Swiss banking titan UBS made an ominous announcement, becoming the inaugural central bank to disclose staggering losses amounting to $3.4 billion due to subprime-linked investments.

In the ensuing months, the Federal Reserve and other central banks embarked on a concerted effort to inject billions of dollars into the stagnant global credit markets, which were paralyzed by plunging asset values. Simultaneously, financial institutions wrestled with the formidable task of evaluating the worth of the trillions of dollars worth of now-toxic mortgage-backed securities that languished on their balance sheets.

March 2008: The Downfall of Bear Stearns

As the winter of 2008 descended, the US economy was engulfed in a profound recession. Concurrently, the ongoing liquidity struggles of financial institutions triggered a worldwide stock market downturn of unprecedented magnitude, rivaling the aftermath of the September 11 terrorist attacks. In January 2008, the Federal Reserve made an unprecedented move by cutting its benchmark rate by 0.75 percentage points. This measure was implemented in a bid to mitigate the accelerating economic downturn.

However, grim tidings persisted from various quarters. In February, the British government was compelled to nationalize Northern Rock, grappling with its financial predicament. Then, in March, the venerable global investment bank Bear Stearns, a cornerstone of Wall Street since 1923, succumbed to insolvency, ultimately acquired by JPMorgan Chase for a mere fraction of its former value.

September 2008: Lehman Brothers' Dramatic Collapse

As the summer of 2008 unfolded, turmoil swept the financial sector. IndyMac Bank met its demise, ranking among the largest bank failures in the United States, according to the FDIC. Moreover, the two largest home lenders in the nation, Fannie Mae and Freddie Mac, found themselves under the control of the US government.

Nevertheless, the defining moment arrived in September, as the venerable Wall Street institution, Lehman Brothers, succumbed to insolvency, registering the most substantial bankruptcy in US history. This event would come to symbolize the profound repercussions of the global financial crisis.

Simultaneously, within the same month, financial markets experienced a steep descent, with major U.S. indexes suffering some of the most substantial losses in their history. The Federal Reserve, the Treasury Department, the White House, and Congress grappled with crafting a comprehensive plan to stem the bleeding and rekindle faith in the economy.

The Post-Crisis Landscape

In October 2008, the Wall Street bailout package was approved, leading to a comprehensive set of measures. This encompassed a substantial government acquisition of "toxic assets," a significant investment in bank stocks, and crucial financial assistance for Fannie Mae and Freddie Mac.

The government disbursed funds amounting to the Troubled Asset Relief Program (TARP), eventually recouping $442.6 billion after profitably reselling assets acquired during the crisis. While public outrage over the apparent rewards bestowed upon bankers for their role in the economic turmoil was widespread, it is noteworthy that the government fully recovered its investments in the banks, including interest.

The enactment of the bailout package played a pivotal role in stabilizing the stock markets, which hit rock bottom in March 2009, subsequently initiating the longest bull market in their history. However, the fallout from the crisis was profound, inflicting severe economic damage and widespread suffering. Unemployment soared to 10%, and approximately 3.8 million Americans lost their homes to foreclosure.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 emerged as the most ambitious and contentious endeavor to avert a recurrence of such a catastrophe. On the financial front, the act curbed some of the riskier practices of significant banks, bolstered government oversight of their operations, and mandated larger cash reserves. Concurrently, it sought to mitigate predatory lending practices. By 2018, select provisions of the act had been scaled back by the Trump Administration, although comprehensive dismantling attempts in the US Senate faltered.

While these regulations aimed to prevent a reiteration of the 2007-2008 crisis, it is vital to acknowledge that future financial crises remain possible, as bubbles have periodically emerged since the Dutch Tulip Bubble of the 1630s. It is crucial to underscore that the 2007-2008 financial crisis was a global phenomenon extending beyond US borders. Ireland's thriving economy plummeted, Greece grappled with international debt defaults, and Portugal and Spain were mired in extreme unemployment levels. Each nation's experience was marked by unique and intricate challenges.

Assessing Responsibility for the Great Recession

The origins of the Great Recession have been a subject of scrutiny by numerous economists, with many attributing a significant portion of the blame to lenient mortgage lending policies that permitted consumers to borrow well beyond their financial means. However, culpability extends beyond this single facet and encompasses various stakeholders, including:

  1. Predatory lenders actively promoted homeownership to individuals with no viable means to repay the mortgages they were extended.
  2. Investment experts who acquired these problematic mortgages and bundled them into packages for subsequent resale to investors.
  3. Regulatory agencies that assign top-tier investment ratings to these mortgage bundles falsely convey a sense of security.
  4. Investors who neglected to verify the ratings or deliberately offloaded these bundles to other investors before their inevitable collapse.

What Are Mortgage-Backed Securities?

A mortgage-backed security (MBS) resembles a bond, comprising a collection of home loans consolidated and vented by the lending banks to Wall Street investors. The fundamental objective is to profit from mortgage holders' interest payments.

During the early 2000s, loan originators actively encouraged countless individuals to overextend their borrowing capacity, enabling them to purchase homes exceeding their financial means. Subsequently, these loans were bundled and conveyed to investors as mortgage-backed securities.

Unavoidably, those homeowners who had overreached their financial limits were in default. This, coupled with a decline in housing prices, prompted millions to relinquish mortgages that had surpassed the value of their homes.

Beneficiaries of the 2008 Financial Crisis

The 2008 financial crisis saw several savvy investors capitalizing on the chaos, often by salvaging opportunities from the wreckage.

  1. Warren Buffett directed billions into various companies, including Goldman Sachs and General Electric, motivated by patriotic and profit-oriented reasons.
  2. Hedge fund manager John Paulson accumulated substantial wealth by taking bearish positions against the US housing market during the bubble's formation and profiting from its rebound after reaching its nadir.
  3. Investor Carl Icahn demonstrated his adept market-timing prowess by strategically selling and acquiring casino properties before, during, and after the crisis.

Conclusion

Financial bubbles are a commonplace occurrence in the world of finance. The value of stocks and various commodities can often become artificially inflated, surpassing their intrinsic worth. Typically, such bubbles result in losses for a handful of overly optimistic investors. However, the financial crisis of 2007-2008 stood apart as a unique and devastating breed of bubble. It reached a magnitude so vast that when it finally burst, it inflicted profound harm on entire economies and affected millions, including those without involvement in speculating with mortgage-backed securities.

2008 Financial Crisis
Lehman Brothers
Great Recession
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