What Caused the 2008 Financial Crisis? Read on, to Find out …
The worst financial crisis since the 1929’s Great Depression caught most everyone by surprise, from Wall Street to Main Street. In hindsight, the conditions that led to 2008’s financial crisis and subsequent Great Recession were well-entrenched years before, making a crisis of some sort practically inevitable. Understanding the root causes of the crisis, how the dominoes began to fall into the Great Recession, and what the lingering effects are today may grant insight into future financial pitfalls.
Still Waters Run Deep
To get an appropriate grasp on what exactly forced the global financial system to nearly fail in 2008, we have to start a few years before, when financiers on Wall Street began to package together suspicious-looking mortgages into fiscally palatable packages.
So-called “subprime” mortgage seekers, or folks who were seeking housing loans with poor or non-existent credit, were issued loans. These collections of risky loans were collected together by financial institutions into securities, allegedly to reduce the overall risk by pooling them together.
The model was based on insurance, whereby a large number of unrelated entities are linked together to spread the risk over the entire group. The failure in this model was that property market nationwide was linked together. Instead of the region-specific model that had served the U.S. well for decades, the housing market as a whole began to rise and fall in tandem. In 2006, specifically, the housing market in the U.S. began to lose value.
A further derivative layer was added when the collected mortgage securities were used to back an additional form of security known as a collateralized debt obligation, or CDO. These CDOs were then issued outstanding credit ratings by supposedly independent ratings agencies, like Standard & Poor’s. The issue was the ratings agencies were merely doing the bidding of their banking customers rather than performing rigorous, independent ratings. In essence, the banks were paying to have their risky CDOs rubber-stamped by the agencies.
The low interest rates attached to these CDOs drew investors like moths to a flame, pumping more and more money into a system that ultimately rested on creditors with no means to support them. It was like an ever-growing tower built on a foundation of sand.
It was like an ever-growing tower built on a foundation of sand.
The foundation ultimately gave way when the housing market suffered a serious downturn. The CDOs that depended on the pooled mortgage securities began to plummet in value, and investors began a fevered rush to drop them at all costs in 2007. It was this domino effect that would ultimately lead to widespread bank failures, including the landmark Lehman Brothers bankruptcy that officially kicked off the financial crisis.
A financial tool known as credit default swaps were the final nail in the financial coffin. Credit default swaps act similar to insurance policies – they are a bet between a seller and a buyer on the status of a third-party loan. If the third party defaults on its loan, the seller agrees to cover the cost to the buyer. If the third party does not default, the buyer continues to pay the seller a premium, not unlike a monthly insurance premium.
A financial tool known as credit default swaps were the final nail in the financial coffin.
Following the Lehman Brothers bankruptcy, U.S. insurance titan AIG collapsed as its credit default swaps finally came due. Quite simply, there was not enough money circulating in the real-world market to cover the vast derivative positions that had been built up. Furthermore, those vast derivative positions were ultimately based on the flimsy and risky mortgage pools.
Lehman Brothers filed for bankruptcy on September 15, 2008, Image from Business Insider
There were multiple points of failure on the way to the 2008 financial crisis. Had banks not been eager to issue risky loans to unqualified creditors, no mortgage pools would have been established. Had ratings agencies acted in a truly independent manner, CDOs would not have been able to stand on the paper-thin mortgage pools. Had those ratings been poor – as they should have been – investors would not have pumped so much auxiliary money into a system doomed to fail. And, finally, had credit default swaps been more tightly managed by governmental regulatory agencies, the whole system would not have grown so top-heavy. There was even a post-crisis point where the damage could have been mitigated by bailing out Lehman Brothers before it ultimately toppled.
None of those safeguards was activated, however, and the 2008 financial crisis gradually deepened into the so-called Great Recession.
Picking up the Pieces
The Great Recession that followed the 2008 financial crisis was felt in every corner of the globe, despite its origins in the U.S. As a result, it fell on the U.S. government to put things back on track.
The plan ultimately crafted by U.S. Federal Reserve Chairman Ben Bernanke and U.S. Treasury Secretary Henry Paulson called for a $700 billion bank bailout package. It initially received hefty criticism, due to the banks’ roles in causing the crisis in the first place. This resistance was primarily led by the Republican Party, which stalled a vote on the bailout for two weeks while the global economy continued to suffer.
The bailout did eventually make it through the U.S. Congress in a modified form. About $350 billion was used to bail out banks and automotive manufacturers by purchasing stock, with the condition that the money ultimately be paid back to the U.S. taxpayer. As of 2010, U.S. banks had replaced about $194 billion of the total. By 2012, President Obama was telling gathered crowds that “every dime” given to the banks had ultimately been paid back.
About $350 billion was used to bail out banks and automotive manufacturers by purchasing stock, with the condition that the money ultimately be paid back to the U.S. taxpayer.
The remaining $350 billion was not directly used for bailouts or immediate post-crisis patching. An alternative plan was hatched by President Barack Obama’s administration to prime the nation’s financial pump with a $787 billion economic stimulus package. The package is largely credited with formally ending the Great Recession in July 2009.
The trough created by the Great Recession, however, is still being filled piecemeal today, almost a decade later.
A significant amount of backtracking occurred as a result of the Great Recession. Many industrial sectors found credit nearly impossible to find in the early days of the recovery, stunting growth in everything from steel to auto to non-residential construction. Those industries are still dealing with the “new normal” of managing lean inventories and making due with partial credit agreements, tightly tied to extant orders.
Perhaps the most significant lasting fallout from the Great Recession, however, can be seen in the political sphere. Worldwide austerity programs have been put in place to manage debt still hanging around from 2008-2009, while governments concurrently crack down on shady banking practices. However, this was not enough to stave off widespread public protests, like the 2011 Occupy Wall Street movement that still pops up in fits and starts. Some political observers even link the election of U.S. President Donald Trump to middle-class resentment stemming from the financial crisis. Indeed, then-candidate Trump said in 2016 that one of his stated presidential goals was restoring the manufacturing capabilities lost during the Great Recession.
Worldwide austerity programs have been put in place to manage debt still hanging around from 2008-2009, while governments concurrently crack down on shady banking practices.
Although the acute effects of the Great Recession are long gone, the aftershocks will likely be felt in both the U.S. and global economic systems for decades to come.
Featured Image: U.S Money Reserve