The Global Financial Crisis took place between 2007-2008 when the US housing bubble burst. The housing bubble was the result of several factors, including loose lending requirements. During the Global Financial Crisis, real estate prices and stocks dropped sharply as millions of American home owners defaulted on their mortgages.
This resulted in a contraction of the derivatives market. Most notably, the market for mortgage-backed securities collapsed. Since many institutions held these derivatives on their balance sheets, the crisis affected the broader economy.
There are several factors that contributed to the Global Financial Crisis in 2008. First of all, we have to understand the role of Government-Sponsored Enterprises (GSEs).
President Roosevelt introduced GSEs after the Great Depression. As part of his New Deal, certain financial institutions received a special status. Federal Finance Housing Agency: “A Brief History of Housing Government-Sponsored Enterprises” Accessed May 20, 2022.
Among the most important GSEs were Fannie Mae and Freddie Mac. These enterprises allowed the government to expand mortgages to consumers in a way that private institutions couldn’t.
Traditionally, when banks offer mortgages to consumers, they keep the mortgages on their balance sheets for 30 years or longer. They also face the possibility that the home owners default on their mortgages during this period.
As a result, commercial banks tend to have relatively strict lending requirements. They only provide mortgages to people who have sufficient income and credit scores. And they require a substantial down payment.
This is where Fannie Mae and Freddie Mac step in. Instead of holding mortgages until maturity, commercial banks could sell their mortgages to Fannie Mae and Freddie Mac on the secondary market.
This means, Fannie Mae or Freddie Mac took the mortgages onto their balance sheets. This also transferred the default risk from the commercial bank to the Government-Sponsored Enterprise. The bank could now take the proceeds from selling the mortgage and extend additional mortgages to consumers.
Commercial banks repeated this process over and over again. This led to Fannie Mae and Freddie Mac owning a large percentage of all US mortgages.
Additionally to the involvement of Fannie Mae and Freddie Mac, political pressure in the United States grew to reduce home ownership inequality. Specifically, the goal was to make home ownership more feasible among lower income households.
Leading up the Global Financial Crisis in 2008, Fannie Mae and Freddie Mac had to purchase at least 50% of their mortgages from the low-income bracket. Summers, Graham: The Everything Bubble. The Endgame for Central Bank Policy (2017), pp. 97. This incentivized commercial banks to provide mortgages to people with low income who otherwise wouldn’t qualify for a mortgage.
The lax lending requirements led to an uptick in home purchases and an expansion of subprime mortgages. Subprime mortgages are mortgages that are provided to people with lower credit scores.
Many people that in the past didn’t qualify for a mortgage could now purchase a home, despite a high chance that they wouldn’t be able to pay back the money. The risk was transferred from commercial banks to Fannie Mae and Freddie Mac, giving banks free reign to offer more and more risky subprime mortgages.
Finally, lose monetary policies in the early 2000s led to a lot of new money entering the economy. The United States had just witnessed the collapse of the Dotcom Bubble and the September 11 attacks.
Alan Greenspan, chair of the Federal Reserve at the time, decided to lower the federal funds rate to 1% and keep it there between June 2003 and June 2004. Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed May 20, 2022.
When the Federal Reserve lowers the federal funds rate, the rate at which banks provide overnight loans to each other, other interest rates follow suit. This includes mortgages.
Additionally, adjustable-rate mortgages were on the rise. These mortgages often consisted of a teaser rate, which was low at the beginning. As a result of the generally low interest rates and the particularly attractive teaser rates, many people invested in the real estate market.
Combined with the loose lending requirements and the increased risk-taking by banks, people who otherwise couldn’t afford a house or even get a mortgage piled into the real estate market.
There are stories of people owning two or three homes despite having low credit scores. People saw that real estate prices went up and believed that unlike stocks, real estate prices would keep rising forever.
This overconfidence in real estate as a safe haven asset and the ongoing appreciation of home prices led to speculation. Investors bought properties to sell them again shortly after, believing it was an easy way to make money.
A lot of the new money created by the Fed’s loose monetary policy found its way into the real estate market. All these factors combined caused the US housing bubble.
In 2004 the Federal Reserve raised interest rates. By 2006 the federal funds rate was back at 5.25%. Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed May 20, 2022. At the same time, the influx of new home owners reached a peak.
The combination of tighter monetary policy and a slowdown of the real estate bubble led to a contraction in real estate prices.
As interest rates increased, many people couldn’t afford the interest payments on their mortgages anymore. Low-income households that already had a hard time coming up with the money in a low-interest environment, definitely couldn’t pay back their mortgage as interest rates rose.
On top of this, the falling house prices meant that people owed a lot more money than their homes were worth at the new valuations. With negative equity, if home owners sold their homes they would have to pay the difference and realize a significant loss.
This led to a wave of defaults and foreclosures. At the same time, Fannie Mae and Freddie Mac, which owned a lot of these mortgages, were under pressure. Incentivizing home ownership and increased borrowing using GSEs only works when most people pay back mortgages.
When a lot of home owners defaulted on their mortgages, Fannie Mae and Freddie Mac faced bankruptcy themselves. They were taken over by the Federal Finance Housing Agency in September 2008. Federal Housing Finance Agency: Statement of FHFA Director James B. Lockhart (2008)
The US housing bubble alone cannot account for the severity of the Global Financial Crisis in 2008. Not just home owners and Government-Sponsored Enterprises like Fannie Mae and Freddie Mac were in trouble.
The financial crisis sent shock waves through the international banking system and economy. The reason for this contagion has to do with derivatives.
Derivatives are financial instruments that allow investors to bet or speculate on the underlying value of stocks, bonds, mortgages and other assets. Derivatives markets are often much bigger than the markets of their underlying assets.
The derivatives market grew considerably in the early 2000s. Many new and ever more complex financial products were introduced. This includes collateralized debt obligations, credit default swaps and mortgage-backed securities. Latter played an especially important role in causing contagion across international financial markets.
Fannie Mae and Freddie Mac took the mortgages it bought from commercial banks and bundled them into mortgage-backed securities. These were then sold again to investors on the derivatives market. Fannie Mae: “Mortgage-Backed Securities” Accessed May 20, 2022.
The high default risk caused by loose lending standards and other factors weren’t priced into these derivatives. Many underestimated the default risk, mispricing these derivatives and leading to the US housing bubble spreading to other markets. It’s the involvement of the derivatives market that led to the financial crisis posting a systemic risk for the global financial system.
Many banks around the world ended up holding these derivatives on their balance sheets. As the real estate market collapsed and many defaulted on their mortgages, the derivatives market, including mortgage-backed securities, contracted.
These derivatives became known as “toxic assets”. Since many banks around the world held these assets, trust among banks decreased. A bank didn’t know how much exposure other banks had to these “toxic assets”. This led to inter-bank lending drying up.
Trust in the financial system as a whole collapsed, leading to reduced lending and a contraction of the economy. The systemic risk these “toxic assets” posed was so big that central banks believed it could lead to another deflationary depression similar to the Great Depression.
As the risk of a deflationary depression grew, central banks around the world took drastic and unprecedented measures in an attempt to contain the crisis.
At the time of the Global Financial Crisis in 2008, Ben Bernanke had replaced Alan Greenspan as chair of the Federal Reserve.
Long before the financial crisis, Bernanke studied the Great Depression and deflation. He believed the Great Depression could have been prevented or significantly shortened by more decisive government and central bank intervention. Federal Reserve Bank of St. Louise “Deflation: Making Sure “It” Doesn’t Happen Here : Remarks before the National Economists Club, Washington, D.C.” Accessed April 28, … Continue reading
As a result, Bernanke lowered the federal funds rate to zero. And for the first time in history, the Federal Reserve deployed quantitative easing. Federal Reserve: “Federal Reserve announces it will initiate a program to purchase the direct obligations of housing-related government-sponsored enterprises and mortgage-backed securities … Continue reading As part of its first quantitative easing program, the Fed purchased large amounts of government debt and mortgage-backed securities.
Another way of thinking of this is that the Federal Reserve took many of these “toxic assets” in the form of mortgage-backed securities onto its own balance sheet. This resupplied exposed financial institutions with new base money.
The Federal Reserve bought these derivatives at their “bubble” valuations, preventing “Too Big To Fail” financial institutions from making a loss.
The actions were unpopular at the time. Many in the general public viewed the government and Fed’s rescue packages as a de facto bailout of financial institutions that had engaged in risky practices.
On the other hand, regular American citizens that lost their life savings, faced default or foreclosure, didn’t receive a “bailout”. Despite the criticism, the Federal Reserve viewed these actions as a necessary step to prevent another depression.
Over the course of the next decade, the Federal Reserve engaged in several more quantitative easing programs to deal with the aftermath of the Global Financial Crisis of 2008.
The federal funds rate stayed at 0% between 2008 and 2015. Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed May 20, 2022. In 2015, the Fed began raising rates and announced quantitative tightening.
The effects of the Global Financial Crisis of 2008 were far reaching. Alongside real estate prices, the stock market crashed. At the time of the crisis, over 67% of Americans were home owners and many owned stocks. Statista: “Homeownership rate in the United States from 1990 to 2021” Accessed May 20, 2022.
The major downturn in both asset classes wiped out the savings of countless Americans. Furthermore, many banks and financial institutions that had exposure to “toxic assets” went bankrupt or were on the brink of it.
On September 15, 2008, Lehman Brothers went bankrupt. Before that, many other financial institutions became insolvent, including American Home Mortgage, NetBank and Delta Financial Corporation.
Goldman Sachs, Morgan Stanley and American Express converted to bank holding companies in order to receive support from the Federal Reserve. Banks and financial institutions that were considered “Too Big To Fail” received support, while some of the smaller banks went under.
Many non-financial companies struggled as well as contagion spread throughout the economy. This led to many layoffs, a sharp increase in unemployment and homelessness.
The recession that followed the Global Financial Crisis of 2008 is often referred to as Great Recession. It wasn’t as severe as the Great Depression. Nevertheless, it went down in history as one of the most severe economic crises in recent times.
It took house prices and the stock market a long time to recover. And the effects of the Global Financial Crisis could still be felt across the world for a long time.
|↑1||Federal Finance Housing Agency: “A Brief History of Housing Government-Sponsored Enterprises” Accessed May 20, 2022.|
|↑2||Summers, Graham: The Everything Bubble. The Endgame for Central Bank Policy (2017), pp. 97.|
|↑3, ↑4, ↑9||Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed May 20, 2022.|
|↑5||Federal Housing Finance Agency: Statement of FHFA Director James B. Lockhart (2008)|
|↑6||Fannie Mae: “Mortgage-Backed Securities” Accessed May 20, 2022.|
|↑7||Federal Reserve Bank of St. Louise “Deflation: Making Sure “It” Doesn’t Happen Here : Remarks before the National Economists Club, Washington, D.C.” Accessed April 28, 2022.|
|↑8||Federal Reserve: “Federal Reserve announces it will initiate a program to purchase the direct obligations of housing-related government-sponsored enterprises and mortgage-backed securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae” Accessed April. 8, 2022.|
|↑10||Statista: “Homeownership rate in the United States from 1990 to 2021” Accessed May 20, 2022.|