The Financial Crisis of 2007-08

The Financial Crisis of 2007-08

Also referred to as the Subprime Mortgage Crisis, the financial crisis of 2007/08 was triggered by the collapse of the US housing market. Cheap credit, lax banking regulations, and lenient lending conditions helped fuel the US housing market bubble, and its eventual collapse turned out to be catastrophic. It led to the collapse of numerous banking institutions and triggered the Great Recession, which was the worst financial crisis the US had witnessed since the Great Depression in the 1930s.

The Background

Following the dot-com bubble burst at the turn of the millennium, the US Federal Reserve bank embarked on a rate-cutting spree in a bid to rejuvenate an economy that had been badly battered. By December 2001, the federal funds rate had been cut to 1.75%, down from 6.5% in May 2000. The central bank continued its dovish stance until June 2003, when the federal funds rate stood at 1%. While the aim was to prevent a looming recession, the resulting high liquidity encouraged banks and the overall public to spend and invest more.

Low-interest rates allowed banks to extend credit at prime lending rates to subprime borrowers. Prime borrowers are low-risk customers, such as major corporations and high net worth individuals, who are able to access loans at great lending rates. In contrast, subprime borrowers are high-risk customers with bad credit scores who generally access loans at higher rates, or they are even unable to get loans sometimes. During the low rates period, banks were encouraged to extend credit to subprime borrowers at prime rates. Consumers then took advantage of the low rates to boost their lifestyle spending, and in particular, to take on mortgages. It was now a legitimate dream for literally anyone to own a home.

Home-buyers had every incentive to take huge mortgages. There were easy initial loan terms, and home prices were on a long-term uptrend. Many buyers figured they could easily refinance at easier, flexible terms as their properties continued to appreciate in value. It was also lucrative for banks and other financial institutions. By lending money to subprime customers, they could repossess the homes in case of defaults and sell them for more than the original loan amounts. Subprime lending would further be promoted by the securitisation of mortgages. The mortgage-backed securities (MBSs) consisted of numerous subprime mortgages bundled together, and they were sold as low-risk bonds that entitled buyers to a share of the loan payments and interest. MBSs became incredibly popular as credit agencies gave them favourable ratings and home prices continued to soar. For the banks selling them, MBSs became a huge source of constant liquidity and risk diversification.

The Housing Bubble and Burst

All the underlying economic conditions saw homeownership peak in the US around 2004 at over 69 per cent. Of particular concern was the share of subprime mortgages that peaked at 15% during the bubble years of 2004-2007 compared to the average of under 2.5% before the turn of the millennium.

Then in June 2004, the US Fed changed its monetary stance and started hiking interest rates. Within only two years, the federal funds rate stood at 5.25%, a level that was maintained until 2007. The era of cheap credit was over, and by 2006 home prices had peaked while interest rates had consistently gone higher. Home prices started drifting lower, and homeowners were facing new troubles.

It was very expensive for them to refinance their mortgages and they were not able to sell their homes without remaining indebted to their lenders. The worst group of debtors were, of course, the subprime customers, who could not initially afford the loans but now made up more than 30% of mortgage holders. In 2007, problems escalated as it became clear that mortgage-backed securities were a toxic investment whose risks could not be quantified accurately.

By the first quarter of 2007, at least 25 subprime lending firms had filed for bankruptcy. The major investment bank, New Century, also filed for bankruptcy in April, while Bear Stearns liquidated two of its hedge funds in June. Things were quickly getting out of hand and the tumbling asset prices inspired panic beyond the US borders. Stock prices started tumbling in China, Europe, and the US, prompting a coordinated approach by multiple central banks.

The global interbank market, which is crucial for banks to maintain liquidity, froze as panic gripped the global economy. By late 2007, Swiss bank UBS reported losses in excess of $3.4 billion, while the UK bank Northern Rock had requested emergency financial backing from the Bank of England. The US Fed had already started cutting rates and even providing loans to major banks to prevent a liquidity crisis. But it was seemingly too little too late.

Markets kept tumbling as banks continued to stare at losses that ran into trillions due to overexposure in mortgage-backed securities. Bad headlines continued to hit the wires and the financial crisis accelerated into 2008. In the UK, Northern Rock was nationalised by the government in February 2008, while in the US, Bear Stearns was acquired cheaply by JP Morgan in March 2008. That year, the crisis continued to spread deeply into the financial sector. By July 2008, US major home lenders, Freddie Mac, and Fannie Mae, had been seized by the government, and IndyMac, one of the country’s biggest-ever banks, collapsed. But the biggest shocker would be the sinking of Lehman Brothers in September 2008, an investment bank that had deep tentacles in the US and global financial systems.

The US Fed continued intervening and by December 2008, the federal funds rate had been cut to zero. It took a little longer for the trickle effects to be felt in the economy and the recession continued into 2009. By the time the Great Recession ended in mid-2009, over 8.8 million jobs had been lost in the US and 8 million home foreclosures had been performed. The US equity markets shed over $7.4 trillion in value and households lost over $19.2 trillion in wealth.

The Aftermath

All stock market crashes come to an end eventually, but not without lessons to be learned and measures to be taken to prevent their recurrence or at least their severity in the future. It was clear that financial institutions had become greedy and were taking so much risk using their funds. There was no care to give loans to quality borrowers, and established financial institutions considered themselves literally ‘too big to fail’. Wall Street had been given too much freedom and there was a real desire to rein in on them through regulation.

Much earlier during the crisis, Congress approved the Troubled Assets Relief Program (TARP), which helped cushion many banks by providing liquidity loans in exchange for ‘preferred stock’ for the US Treasury. The program that was established in September 2008 would prove practical and its benefits extended beyond the intended financial institutions. TARP funds helped rescue bankruptcy-threatened insurance titan AIG in November 2008 as well as automakers Ford, Chrysler, and GM in December 2008. The funds were also used to help homeowners restructure their mortgage terms in February 2009.

But a long-term solution was required. And it came in the form of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The Act sought to overhaul regulation in Wall Street by promoting fiscal responsibility, greater consumer protection as well as increased government oversight. The Act sought to correct the notion of institutions that are ‘too big to fail’ by actively monitoring the stability and risk exposure of big institutions that pose systemic risks.

Banks also had to boost their reserves and were barred from risky speculative trading or close association with hedge funds and private equity firms. Consumers would also be protected by having rights to clear and transparent investing information while predatory lending was reined in. Furthermore, the US SEC formed a department that ensured credit rating agencies provided accurate ratings of investment products so that investors could understand the underlying risks beforehand. The Act also expanded the whistle-blower program to make it lucrative for those that report irresponsible acts of financial institutions.

Final Word

Before the Great Lockdown of 2020, the Great Recession was the worst ever financial crisis since the Great Depression of the 1930s. The crisis illustrated the importance of holding financial institutions accountable and how valuations and sentiment can take markets to the extreme. It is still considered immoral to date that taxpayer money was used to bail out institutions that were, arguably, the cause of the crisis that wrecked many households. The government and central banks cannot afford to leave such institutions to their own designs. For investors and the general public, the 2008 financial crisis is a lesson on the dangers of overextending credit or taking on highly leveraged investments. It is also a lesson on the importance of proper diversification and asset allocation.