Context
The 2008 Financial Crisis was precipitated by the collapse of a massive, debt-fueled housing bubble in the United States. Following the 2001 dot-com crash, the Federal Reserve maintained historic low interest rates, which simultaneously made home purchases attractive and drove investor demand for higher yields. This environment incentivized the creation of a “giant money machine” that relied on subprime mortgages as its raw material, which were then bundled into increasingly complex securities.
By 2007, the “hot money” fueling these investments began to vanish as early payment defaults spiked, leading investors to question the solvency of the highly leveraged institutions holding these assets. Unlike previous equity-based crashes, the 2008 event was defined by contagion within a deeply interconnected banking system, where the failure of one “domino” threatened to bring down the entire global economy.
The Crisis
The crisis unfolded through a series of “slow-motion horrors” that paralyzed the credit markets. The initial rupture occurred in the shadow banking system, where entities like Structured Investment Vehicles (SIVs) and the repo market faced sudden runs as lenders refused to roll over short-term debt. This created a liquidity trap where institutions could not sell assets except at fire-sale prices, which further depressed values and triggered more forced selling.
The contagion mechanism operated through interconnectedness: banks held each other’s debt, insurance companies like AIG had written protection on trillions in securities, and money market funds that were supposed to be safe held commercial paper from failing institutions. When Lehman Brothers filed for bankruptcy on September 15, 2008, it demonstrated that even a massive firm could be allowed to die, triggering a “run” not by depositors but by institutional investors who pulled their funding from any firm perceived as weak.
Consequences
The collapse forced the U.S. government to abandon its “no bailout” rhetoric and enact the TARP program to prevent the complete disintegration of the global credit system. The Federal Reserve expanded its balance sheet from under $1 trillion to over $2 trillion through emergency lending. The crisis resulted in the Great Recession, the worst economic downturn since the 1930s, with unemployment reaching 10% and millions of Americans losing their homes.
The regulatory response included the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which created new oversight mechanisms and attempted to address the “too big to fail” problem. However, critics argue that the fundamental structure of finance remained unchanged, with large banks growing even larger and the implicit government guarantee more entrenched.
Key Developments
- 2004: SEC allows investment banks to use internal models for capital, enabling leverage ratios above 30-to-1.
- 2006: Housing prices peak and begin to decline nationally.
- February 2007: HSBC announces massive losses on subprime mortgages.
- August 2007: BNP Paribas freezes three funds, triggering the credit crunch; central banks inject emergency liquidity.
- March 16, 2008: The Federal Reserve subsidizes the takeover of Bear Stearns by JPMorgan Chase for $2 a share.
- September 7, 2008: The U.S. government places Fannie Mae and Freddie Mac into conservatorship.
- September 15, 2008: Lehman Brothers files for bankruptcy after the government refuses a bailout, triggering a global collapse of confidence.
- September 16, 2008: The Reserve Primary Fund “breaks the buck,” causing a massive run on the $3.4 trillion money market fund industry.
- September 16, 2008: The U.S. government provides an initial $85 billion bailout to AIG.
- September 21, 2008: Goldman Sachs and Morgan Stanley convert to bank holding companies to gain access to the Federal Reserve’s “discount window.”
- October 3, 2008: President Bush signs the Emergency Economic Stabilization Act, creating the $700 billion TARP.
- January 2009: Bank of America receives a second bailout to complete its acquisition of Merrill Lynch.
- July 21, 2010: President Obama signs the Dodd-Frank Wall Street Reform and Consumer Protection Act into law.