April 4, 2017    11 minute read

The 2008 Financial Crisis: Causes, Consequences and Lessons Learned

Where to from Here?    April 4, 2017    11 minute read

The 2008 Financial Crisis: Causes, Consequences and Lessons Learned

The 2008 financial crisis is a tale of corporate greed, poor governance and goes to show that if you ride like lightning, you really do crash like thunder. The crisis followed a period of economic stability and growth in developed countries around the world, a period known as the Great Moderation.

Much of this optimism created an environment in which regulators became complacent and financial institutions took to riskier methods of increasing returns.

What most did not see is that the combination of these two factors would lead to an economically crippling crisis. One which would see its effects continue to be felt for years to come.

The Boom

Following the burst of the dot-com bubble in 2001 and the recession that ensued, the Fed engaged in expansionary monetary policy. This meant continuously slashing interest rates, which was perhaps further encouraged by the fact that inflation remained low despite a decline in the interest rate.

Low-interest rates have two basic effects; they incentivise borrowing and discourage saving. For financial institutions, this meant the low borrowing costs that resulted encouraged them to excessively borrow funds to purchase more assets. Not only did this lead to leveraged asset purchasing but it encouraged them to invest in riskier, more ‘toxic’ assets to maximise their returns.

This inevitably increased the risk of them defaulting on their debt repayments, becoming insolvent and could end in filing for bankruptcy. For consumers, this also meant cheaper borrowing, and for many across the US, they saw it as an opportunity to finally become a homeowner. The issue, however, was that many of these potential homeowners were on little to no income and had poor credit histories; they had a habit of defaulting on loans. Fortunately for them, banks and mortgage lenders had developed an appetite for risk and decided to give mortgages to these subprime borrowers. Thus, began the period of subprime mortgage lending in the US.

This proved to be popular across the nation; the combination of low-interest rates and the willingness of banks to lend encouraged consumers to take out loans and purchase mortgages, which inevitably drove up house prices due to high demand. Meanwhile, banks were pooling these risky mortgages to back financial instruments such as mortgage-backed securities (MBSs) and collateralised debt obligations (CDOs). Supported by low-interest rates, hedge funds, banks and similar institutions were incentivised to invest in these risky instruments. Despite the risk, investment in these instruments seemed to be a safe bet; they had received stellar AAA credit ratings from credible ratings agencies and promised to yield high returns for minimal risk. After all, who doesn’t pay their mortgage?

The Bust

As it turns out, paying one’s mortgage became increasingly harder. By 2004, home ownership had reached its peak and by the third quarter of 2006 house prices were in decline, and so burst the housing bubble. The Fed had also begun increasing interest rates in an attempt to combat inflation, which subsequently increased the cost of borrowing, thereby discouraging borrowing and make saving more attractive.

This increased the value of the mortgage repayments subprime borrowers had to pay. As many of these individuals had no means of refinancing, and could not sell their homes for a profit due to the depreciation in value, they began to default on their mortgages. Although mortgage-backed securities were initially designed to reduce and disperse risk, the rise in mortgage defaults led to a decrease in the value of MBSs and CDOs which, in turn, spread the losses felt by banks and investors.

It also led to a number of small, subprime lenders to file for bankruptcy as leveraging their equity had resulted in insolvency. All in all, the financial crisis had set in, and the impacts of it were about to be felt throughout the global economy.

The Consequences

By 2007, uncertainty was widespread throughout the financial markets. Mortgage defaults were still on the rise, forcing banks to write off billions in losses and with this came the credit crunch. Unsurprisingly, banks had become unwilling to lend to individuals with a less than perfect credit history.

Not only did this affect consumers, but business too found it harder to borrow funds to finance expenditure. A lack of business expenditure could have a negative effect on both the demand and supply-side of the economy; a lack of investment both reduces aggregate demand as well as leads to a decrease in the productivity and possibly size of the workforce. As this trend became increasingly common, it was clear that the US could face a potential recession.

But the effects were not being felt just in the US, they had spread across the globe. The tightening of credit issued by banks proved to be a major problem for UK bank Northern Rock. They had borrowed large sums of money to finance mortgage lending and relied on capital markets to resell those mortgages.

However, with the subprime market crisis in full effect, investors were turning away from the market. This left Northern rock with a liquidity crisis; they had to make their debt repayments but had no means of short-term funding. As a result, in September 2007 they turned to the lender of the last resort, the Bank of England. This sparked fear and panic amongst their depositors, and within a day customers had begun withdrawing their savings.

2007 also saw central banks around the world, from Canada to China, begin to intervene in an attempt to mitigate the consequences the crisis would have on their economy.

In 2008, matters only got worse, especially for the banks. By February 2008, the decision had been made to nationalise Northern Rock. March 2008 saw JP Morgan acquire Bear Sterns, a firm who had to close two of its hedge funds in 2007 due to the losses they had suffered on mortgage-backed securities.

But the biggest casualty of the financial crisis struck in September as one of the largest investment banks at the time, Lehman Brothers, filed for bankruptcy. Lehman had built itself a large portfolio of mortgage-backed securities which were decreasing in value, and since the acquisition of Bear Sterns, investors were worried about the wellbeing of Lehman, fearing that it too could come close to failure. This worry turned into a lack of confidence in the firm which in turn drove their stock down by 77% in the first week of September 2008, but that was just the start.

In the days the followed, their stock value continued to plunge as bad news came in from all sides; Moody’s threatened a credit ratings downgrade and their lines of credit were being cut-off. To salvage what was left, Lehman attempted to organise their own takeover, holding talks with Bank of America and Barclays.

However, these were unsuccessful and on September 15th, 2008, Lehman Brothers filed for bankruptcy. It was clear to everyone, from bankers to regulators to consumers all over the world that this crisis had left a trail of severe economic destruction that would take years to clean up.

The Aftermath

Intervention from government and central banks all over the globe was in full swing. In September, the US Fed gave AIG, an insurance company, an $85bn rescue package to prevent its bankruptcy in return for an 80% stake in the firm. This led some to question their reasoning behind rescuing AIG but not Lehman Brothers. After all, Lehman Brothers was the fourth-largest investment bank at the time.

The US government responded by stating that the bankruptcy of AIG could “present a systematic risk to the financial system, while a Lehman bankruptcy would not”. In October, the Treasury then proposed a $700bn bailout plan. This would involve the government purchasing impaired assets, especially mortgage-backed securities, and then reselling them after market conditions improved.

However, this did not work to the extent at which they initially thought it would; market conditions instead continued to worsen. The US Treasury deemed it would be more effective to invest directly into the firms themselves, so decided to respond by investing $250bn into a variety of small and key financial institutions.

$700bn was the value of the proposed bailout plan

In the meantime, the UK government induced an expansionary fiscal policy; VAT was cut from 17.5% to 15% in an attempt to increase consumption. In October, the government also agreed to inject £37bn into RBS and Lloyds TSB, following the agreed takeover of HBOS by Lloyds TSB back in September. This action effectively nationalised the two banks as it meant that the state owned 81% of RBS and 40% of Lloyds TSB.

To stimulate consumer expenditure within the economy, the Bank of England had cut interest rates from 5% to 0.5% between 2008 and 2009. This meant that, by 2009, the UK had little further scope to cut interest rates.

So instead, the Bank of England turned to unconventional monetary policy and engaged in quantitative easing. The aim of this was to create new money electronically for firms to invest in stock and bond markets, this, therefore, raises asset prices whilst also boosting liquidity and encouraging lending.

Then, in April 2009, the G20 summit took place in London, where the leaders discussed potential methods of slowing down further economic destruction. They came to an agreement to inject roughly £681bn into the global economy.

April also saw the establishment of the Financial Stability Board. The objective of this international body was to work alongside the IMF to conduct early warning exercises and assess the vulnerabilities within the global financial system to better inform regulators and policymakers.

These were not the only changes that were inflicted upon regulatory bodies; many governments had realised banks were not the only ones to blame for causing the crisis. It was clear regulatory bodies were overly complacent and that there was a lack of prudential regulation. For both the UK and the US, the coming years saw significant changes in regulatory methods in an effort to learn their lesson.

The Lessons

Policymakers realised that monetary policy should consider financial as well price stability and emphasised the necessity of macro-prudential regulation. As of April 1st, 2013, after the Financial Services Act of 2012 was put in place in the UK, the Financial Services Authority (FSA) was replaced by the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA).

With these two also came the creation of the Financial Policy Committee (FPC), with the PRA and FPC both being parts of the Bank of England.  The PRA has the role of ensuring the stability of the UK financial system by being responsible for the prudential regulation for a vast number of financial institutions.

The FCA, which is not a part of the Bank of England, is essentially responsible for making sure firms within the financial market behave in an appropriate way. By doing this, they also establish and aim to maintain competition within the markets, so that firms cannot abuse any market power they own.

Finally, the FPC is tasked with the responsibility of identifying systemic risks as well as instructing the PRA and FCA on actions they take to reduce these risks.

Meanwhile, in the US, reforms were also underway. The Dodd-Frank Act had passed in 2010 under the Obama administration; it stated that companies with assets valued above a certain level should abide by capital and liquidity requirements as it aimed to decrease the number of risks in their financial system. It also prohibited banks working alongside hedge funds as this was deemed too risky and also limited the ways banks can invest.

Critics of Dodd-Frank argued that although the act would protect consumers and reduce the vulnerability of their financial system, it would also reduce the ability of banks to make profits similar to what they saw pre-financial crisis.

Conclusion

Now nearly 10 years on, the majority of economies that were affected by the storm brought on by the collapse of the US financial system have since recovered. But, there are many changes that have recently occurred that threaten the future stability of global financial markets.

From Brexit to the unpredictability of the Trump administration, there’s no telling what these changes have in store. Brexit has created a climate of economic uncertainty which has led to major global banks such as HSBC wanting to relocate up to 1000 staff.

In the US, Trump has promised to ease the regulation imposed on the banking industry. His party argues that the Dodd-Frank Act is far too restrictive on financial institutions, with Sean Spicer, White House press secretary, saying that “Dodd-Frank is a disastrous policy that’s hindering our markets”.

Therefore, one can expect to see the impact of the Dodd-Frank Act, an act imposed with the objective to prevent a similar financial crisis from occurring again, begin to diminish. All in all, what’s clear is that although the storm of the financial crisis has since passed, dramatic changes in the geopolitical stage have created a cloud of economic uncertainty. Whether this cloud turns into a storm similar to what that of 2008, only time will tell.

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