What Caused the 2008 Financial Crisis?

A number of negative economic and financial trends and events all came together to contribute to the financial crisis of 2007–2008 and the Great Recession of 2008–2009. A rapid decline in housing prices began in 2006. This led to increased unemployment, first in housing-related activities and then more broadly. 

As a result, many homeowners were forced to default on their home mortgage loans. These developments occurred at a time when individuals, financial institutions, and business firms were heavily in debt. The result was a so-called “perfect financial storm” accompanied by a fear that the financial system might collapse.

While there continues to be some disagreement as to specific causes of the financial crisis, most economists and others trace the beginning of the crisis to the bursting of the U.S. housing bubble in mid-2006. 

Causes of the 2007-2008 Financial Crisis 

For a period of time prior to mid-2006, housing prices were continually rising year over year with some areas of the United States experiencing annual double-digit housing price increases. The first part of the twenty-first century was a time when U.S. federal government policies encouraged homeownership. 

Lenders were willing to lend to financially “risky” borrowers seeking mortgage loans to make home purchases, and individual borrowers were willing to take on excessive amounts of mortgage debt, all in the belief that housing prices would continue to rise. 

Once housing prices began to decline, many homeowners had the equity in their homes “wiped out” and many mortgage loans became “underwater,” which occurs when mortgage debt on the home exceeds the value of the home. This rapid decline in housing values was accompanied by a major loss of jobs in home construction and related industries.

Many home mortgage loans were combined into “pools” of loans, and then mortgage-backed securities were issued with the mortgage loan pools as backing or collateral. Large amounts of mortgage-backed securities were held by banks and other financial institutions, and as home prices collapsed it became clear that this mortgage-backed security had been previously overvalued and they also declined sharply in value. 

A “credit crunch” occurred when banks and other financial institutions found that they did not have adequate equity capital to cover their large mortgage loan and other debt commitments. 

As a result, financial institutions were forced to lay off many employees. Businesses found it difficult to borrow from banks and other financial institutions because of the credit crunch, causing even higher levels of unemployment.

During 2008, the federal government helped some financial institutions to merge, “bailed out” a number of institutions and businesses, and allowed other financial institutions to fail. The financial crisis and associated credit crunch were accompanied by the 2008–09 economic downturn, which began in early 2008 and ended in mid-2009 with economic activity declining more than 10 percent and the unemployment rate exceeding 10 percent. 

The 2008–09 economic downturn is referred to as the Great Recession since it involved the largest economic downturn since the Great Depression of the 1930s.

Financial Institution Problems During the Financial Crisis

Homeowners usually finance part of the purchase of their homes with mortgage loans. A mortgage is a loan secured by real property in the form of buildings and houses. Banks and other mortgage lenders bundled the loans they originated into securities during the decade of the 2000s.

Other financial intermediaries have also “repackaged” mortgage loans into mortgage-backed securities.

A mortgage-backed security is a debt instrument created by bundling a group of mortgage loans whose regular payments belong to the holders of the security. The value of these mortgage-backed securities depended on the value of the homes for which the underlying mortgages were issued.

As noted above, housing prices peaked in 2006, after which the value of homes plummeted, leading to the 2007-2008 financial crisis. Housing jobs were lost and unemployment increased, leading to more and more homeowners defaulting on their mortgage loans.

Falling home prices and rising mortgage loan defaults in turn caused the value of mortgage loans and the associated mortgage-backed securities on those homes to fall as well.

In many cases, the value of the homes fell below the value of the underlying mortgages, wiping out all of the homeowners’ equity in the homes. When the mortgage loans exceed the value of the underlying homes, they are said to be “underwater.”

Many banks and other financial institutions that held mortgage loans and mortgage-backed securities as assets ran into liquidity and solvency problems when the values of these loans and securities fell to such low levels that there was concern about whether the financial institutions could meet their obligations as they came due.

This situation was exacerbated by rising unemployment in the United States, leading to a decline in economic activity that culminated in the Great Recession of 2008-2009.

In March 2008, Bear Sterns, a major financial institution, was on the verge of collapse due to a decline in the value of mortgage-backed securities and had to be taken over by JPMorgan Chase & Co. with the help of the Federal Reserve and the U.S. Treasury. By September 2008, the financial crisis was at its peak. Lehman Brothers, a major investment bank, was sent into bankruptcy and Merrill Lynch was sold to Bank of America.

Shortly after the bankruptcy of Lehman and the sale of Merrill, American International Group (AIG), the largest insurance company in the United States, was “bailed out” by the Federal Reserve, with the U.S. government receiving a stake in AIG. Like Merrill, the Federal National Mortgage Association (Fannie Mae), and the Federal Home Mortgage Association (Freddie Mac), AIG was deemed “too big to fail” because of its potential impact on global financial markets.

In late September 2008, Washington Mutual, the largest S&L in the United States, failed, and most of its assets were purchased by JPMorgan Chase.

Wachovia Bank, then the fourth-largest commercial bank in the United States, was also on the verge of bankruptcy before finally agreeing to be purchased by Wells Fargo Bank. Citigroup and Bank of America, the first and second-largest U.S. banks, respectively, were also in financial trouble.

U.S. Central Bank Response to the Financial Crisis

As housing prices continued to rise, this mortgage assistance from Ginnie Mae, Fannie Mae, and Freddie Mac helped achieve the government’s goal of increasing homeownership. 

However, after the housing price bubble burst in mid-2006 and the number of housing jobs plummeted, mortgage borrowers had greater difficulty making their interest and principal payments, causing the value of mortgage-backed securities to plummet.

To make matters worse, Fannie Mae and Freddie Mac held large amounts of low-quality subprime mortgages, which were more likely to default. As default rates on these mortgage loans rose, both Fannie and Freddie faced liquidity crises. To avoid a meltdown, the Federal Reserve provided bailout funds in July 2008, and the U.S. government took control of both companies in September 2008.

The Federal Reserve, sometimes with the help of the U.S. Treasury, helped a number of financial institutions that were on the verge of bankruptcy due to the decline in the value of mortgage-backed securities to merge with other companies.

Examples include the Fed’s assistance in the acquisition of Bear Stearns by JPMorgan Chase in March 2008 and the sale of Merrill Lynch to Bank of America in the second half of 2008. However, Lehman Brothers, a major investment bank, was sent into bankruptcy in September 2008.

Shortly after Lehman’s bankruptcy and the sale of Merrill, American International Group (AIG), the largest insurance company in the United States, was “bailed out” by the Federal Reserve, with the U.S. government receiving a stake in the company. Like Merrill, Fannie and Freddie, AIG was deemed “too big to fail” because of the potential impact on global financial markets.

In addition to direct intervention, the Fed also took quantitative easing measures to prevent a financial system collapse in 2008 and to spur economic growth after the 2008-09 recession.

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