The Financial Crisis of 2007-08

It took years for the financial crisis of 2007–2008 to develop. By the summer of 2007, financial markets all across the world were indicating that a protracted binge on cheap borrowing was finally coming to an end. There had been two Bear Stearns hedge fund failures.

Investors were alerted by BNP Paribas that three of its funds might not allow withdrawal additionally, the British bank Northern Rock was going to ask the Bank of England for emergency funding.

Nevertheless, despite the warning indications, few investors were aware that the world financial system was going to be hit by the biggest crisis in nearly eight decades, which would knock Wall Street’s titans to their knees and cause the Great Recession.

Many common people lost their jobs, their life savings, their houses, or all three as a result of this enormous financial and economic catastrophe.

Sowing the Crisis’s Seeds

A house price bubble in the US and internationally was driven by years of historically low-interest rates and lax lending rules, which laid the groundwork for the financial catastrophe.

As usual, things got off to a good start. The Federal Reserve reduced the federal funds rate from 6.5% in May 2000 to 1% in June 2003 in response to the September 11 terrorist attacks, the dot-com bubble crash, and a slew of corporate accounting scandals.

By making money inexpensively available to consumers and businesses, the economy was intended to be boosted. As a result of borrowers taking advantage of the cheap mortgage rates, housing values began to rise rapidly. Even subprime borrowers—those with bad credit histories or none at all—could fulfill their ambition of owning a home.

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The Wall Street banks bought the loans from the banks after which they packaged them into what was marketed as low-risk financial vehicles, such as mortgage-backed securities and collateralized debt obligations (CDOs). Subprime loan origination and distribution soon saw the growth of a sizable secondary market.

The Securities and Exchange Commission (SEC) lowered the net capital requirements for five investment banks—Goldman Sachs (NYSE: GS), Merrill Lynch (NYSE: MER), Lehman Brothers, Bear Stearns, and Morgan Stanley—in October 2004, encouraging banks to take on more risk (NYSE: MS). That allowed them to up to 30 or even 40 times leverage their initial investments.

Warning Signs

Homeownership eventually reached its saturation point as interest rates began to increase. The Federal Funds Rate reached 5.25% two years after the Fed began hiking rates in June 2004, and it stayed there until August 2007. Early indications of distress were present. Homeownership in the US reached a peak of 69.2% in 2004.

Then, in the first quarter of 2006, property prices began to decline.

For many Americans, this was quite difficult. The value of their properties was lower than what they paid for them. They owed money to their lenders, therefore they were unable to sell their homes. If they had adjustable-rate mortgages, their expenses increased as the value of their properties decreased. The most vulnerable subprime borrowers were forced to stay in mortgages that they couldn’t actually afford.

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One subprime lender after another declared bankruptcy as 2007 got underway. More than 25 subprime lenders failed in February and March. Subprime loan specialist New Century Financial filed for bankruptcy and fired half of its staff in April.

Bear Stearns halted making redemptions in two of its hedge funds before the end of the month of June, which prompted Merrill Lynch to seize $800 million in assets from the funds.

Even these were insignificant issues in light of what lay in store for the upcoming months.

In August 2007, things started to go wrong.

By August 2007, it was clear that the subprime crisis could not be resolved by the financial markets and that its effects extended far beyond the boundaries of the United States.

Because of widespread uncertainty, the interbank market that keeps money flowing around the world entirely shut down. Due to a liquidity issue, Northern Rock had to seek the Bank of England for emergency funding. The first big bank to report losses from investments tied to subprime mortgages was the Swiss bank UBS in October 2007. These losses totaled $3.4 billion.

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The global credit markets, which were collapsing due to falling asset values, would receive billions of dollars in loans from the Federal Reserve and other central banks in the upcoming months. Financial institutions were having trouble determining the value of the hazardous mortgage-backed assets worth trillions of dollars that were still listed on their books.

The Fall of Bear Stearns in March 2008

The U.S. economy had entered a full-fledged recession by the winter of 2008, and as financial institutions struggled to maintain liquidity, stock markets worldwide were seeing their steepest decline since the September 11 terrorist attacks.

In an effort to stop the economy’s decline, the Fed reduced its benchmark rate by three-quarters of a percentage point in January 2008, the largest reduction in twenty-five years.

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The awful news kept coming in from all directions. The British government was compelled to nationalize Northern Rock in February.

Bear Stearns, a major Wall Street institution that dates back to 1923, collapsed in March and was bought for pennies on the dollar by JPMorgan Chase.

Fall of Lehman Brothers in September 2008

By the summer of 2008, the financial industry was being decimated. The two largest home lenders in the nation, Fannie Mae and Freddie Mac, were also taken over by the government of the United States, making IndyMac Bank one of the biggest banks to collapse in American history.

However, the bankruptcy of the famous Wall Street bank Lehman Brothers in September, which was the biggest in American history, became a symbol of the destruction brought on by the global financial crisis for many.

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In the same month, the major U.S. indices had some of their greatest losses ever as the financial markets fell drastically. To stem the bleeding and regain economic confidence, the Fed, the Treasury Department, the White House, and Congress tried to come up with a comprehensive plan.

What Caused the Financial Crisis in 2008?

There were several interconnected elements at play

First, cheap interest rates and lax lending requirements enabled millions to borrow money beyond their means to purchase homes they couldn’t afford. This drove a housing price bubble.

In order to raise funds for more mortgages, the banks and subprime lenders kept up the pace by selling their mortgages on the secondary market.

The financial companies that purchased the mortgages rebundled the mortgages into bundles, or “tranches,” and then sold the mortgage-backed securities to investors. The final buyers discovered they were holding worthless paper when mortgage defaults started to pile up.

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The Great Recession: Who Is to Blame?

Numerous economists attribute the majority of the blame to loose mortgage lending regulations that allowed many individuals to borrow amounts far beyond their means. However, there are many people to hold accountable, including:

1. Opportunistic lenders promoted homeownership to people who would never be able to repay their mortgages.
2. The financial geniuses who purchased those subpar mortgages and packaged them for sale to investors.
3. The organizations that gave the mortgage bundles the highest investment ratings did so to give the impression that they were secure.
4. Investors either neglected to look at the ratings or just took care to sell the bundles to other investors before they went bust.

Exactly which banks failed in 2008?

No depositor in an American bank lost a dime as a result of a bank failure. This information must be reported before revealing the overall number of bank failures associated with the financial crisis.

However, the Federal Reserve of Cleveland reports that over 500 banks collapsed between 2008 and 2015, compared to a total of 25 in the seven years prior.

The majority were modest regional banks that were all bought up by larger institutions along with the depositors’ accounts.

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The largest failures were investment banks that catered to institutional investors rather than regular Main Street banks. Lehman Brothers and Bear Stearns were two of these. After being turned down for a government bailout, Lehman Brothers closed its doors. Bear Stearns’ wreckage was inexpensively purchased by JPMorgan Chase.

As for the biggest of the big banks, they were all infamously “too big to fail,” including JPMorgan Chase, Goldman Sachs, Bank of America, and Morgan Stanley. After the recession, they used the bailout funds, paid them back to the government, and became larger than before.

Who Profited from the Financial Crisis of 2008?

Many wise investors profited from the crisis, largely by salvaging bits from the rubble.

Warren Buffett made enormous investments in businesses like Goldman Sachs and General Electric for a variety of reasons, including profit and patriotism.

When the housing bubble first started, hedge fund manager John Paulson made a tonne of money betting against it. After the bubble burst, he made even more money betting on the housing market’s recovery.

Carl Icahn, an investor, demonstrated his aptitude for market timing by purchasing and selling casinos before, during, and after the crisis.

In conclusion

Bubbles arise all the time in the financial sector. A stock’s price or the price of any other commodity may rise above its true value. The impact is typically restricted to losses for a small number of overly enthusiastic consumers.

There was a distinct kind of bubble during the financial crisis of 2007–2008. Like very few others in history, it got to a size that, when it burst, it injured millions of people, many of whom weren’t investing in mortgage-backed securities, and devastated entire economies.

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