The 2007-2008 Financial Crisis in Review

The financial crisis of 2007-2008 was years in the making. By the summer of 2007, financial markets around the world were showing signs that the reckoning was overdue for a years-long binge on cheap credit. Two Bear Stearns hedge funds had collapsed, BNP Paribas was warning investors that they might not be able to withdraw money from three of its funds, and the British bank Northern Rock was about to seek emergency funding from the Bank of England.

Yet despite the warning signs, few investors suspected that the worst crisis in nearly eight decades was about to engulf the global financial system, bringing Wall Street’s giants to their knees and triggering the Great Recession.

It was an epic financial and economic collapse that cost many ordinary people their jobs, their life savings, their homes, or all three.

Sowing the Seeds of the Crisis

The seeds of the financial crisis were planted during years of rock-bottom interest rates and loose lending standards that fueled a housing price bubble in the U.S. and elsewhere.

It began, as usual, with good intentions. Faced with the bursting of the dot-com bubble, a series of corporate accounting scandals, and the September 11 terrorist attacks, the Federal Reserve lowered the federal funds rate from 6.5% in May 2000 to 1% in June 2003. The aim was to boost the economy by making money available to businesses and consumers at bargain rates.

The result was an upward spiral in home prices as borrowers took advantage of the low mortgage rates. Even subprime borrowers, those with poor or no credit history, were able to realize the dream of buying a home.

The banks then sold those loans on to Wall Street banks, which packaged them into what were billed as low-risk financial instruments such as mortgage-backed securities and collateralized debt obligations (CDOs). Soon a big secondary market for originating and distributing subprime loans developed.

Fueling greater risk-taking among banks, the Securities and Exchange Commission (SEC) in October 2004 relaxed the net capital requirements for five investment banks—Goldman Sachs (NYSE: GS), Merrill Lynch (NYSE: MER), Lehman Brothers, Bear Stearns, and Morgan Stanley (NYSE: MS). That freed them to leverage their initial investments by up to 30 times or even 40 times.

Signs of Trouble

Eventually, interest rates started to rise and homeownership reached a saturation point. The Fed started raising rates in June 2004, and two years later the Federal funds rate had reached 5.25%, where it remained until August 2007.

There were early signs of distress. By 2004, U.S. homeownership had peaked at 69.2%. Then, in early 2006, home prices started to fall.

This caused real hardship to many Americans. Their homes were worth less than they paid for them. They couldn’t sell their houses without owing money to their lenders. If they had adjustable-rate mortgages, their costs were going up as their homes’ values were going down. The most vulnerable subprime borrowers were stuck with mortgages they couldn’t afford in the first place.

As 2007 got underway, one subprime lender after another filed for bankruptcy. During February and March, more than 25 subprime lenders went under. In April, New Century Financial, which specialized in sub-prime lending, filed for bankruptcy and laid off half of its workforce.

By June, Bear Stearns stopped redemptions in two of its hedge funds, prompting Merrill Lynch to seize $800 million in assets from the funds.

Even these were small matters compared to what was to happen in the months ahead.

August 2007: The Dominoes Start to Fall

It became apparent by August 2007 that the financial markets could not solve the subprime crisis and that the problems were reverberating well beyond the U.S. borders.

The interbank market that keeps money moving around the globe froze completely, largely due to fear of the unknown. Northern Rock had to approach the Bank of England for emergency funding due to a liquidity problem. In October 2007, Swiss bank UBS became the first major bank to announce losses—$3.4 billion—from sub-prime-related investments.

In the coming months, the Federal Reserve and other central banks would take coordinated action to provide billions of dollars in loans to the global credit markets, which were grinding to a halt as asset prices fell. Meanwhile, financial institutions struggled to assess the value of the trillions of dollars worth of now-toxic mortgage-backed securities that were sitting on their books.

March 2008: The Demise of Bear Stearns

By the winter of 2008, the U.S. economy was in a full-blown recession and, as financial institutions’ liquidity struggles continued, stock markets around the world were tumbling the most since the September 11 terrorist attacks.

In January 2008, the Fed cut its benchmark rate by three-quarters of a percentage point—its biggest cut in a quarter-century, as it sought to slow the economic slide.

The bad news continued to pour in from all sides. In February, the British government was forced to nationalize Northern Rock. In March, global investment bank Bear Stearns, a pillar of Wall Street that dated to 1923, collapsed and was acquired by JPMorgan Chase for pennies on the dollar.

September 2008: The Fall of Lehman Brothers

By the summer of 2008, the carnage was spreading across the financial sector. IndyMac Bank became one of the largest banks ever to fail in the U.S., and the country’s two biggest home lenders, Fannie Mae and Freddie Mac, had been seized by the U.S. government.

Yet the collapse of the venerable Wall Street bank Lehman Brothers in September marked the largest bankruptcy in U.S. history, and for many became a symbol of the devastation caused by the global financial crisis.

That same month, financial markets were in free fall, with the major U.S. indexes suffering some of their worst losses on record. The Fed, the Treasury Department, the White House, and Congress struggled to put forward a comprehensive plan to stop the bleeding and restore confidence in the economy.

The Aftermath

The Wall Street bailout package was approved in the first week of October 2008.

The package included many measures, such as a huge government purchase of “toxic assets,” an enormous investment in bank stock shares, and financial lifelines to Fannie Mae and Freddie Mac.

The public indignation was widespread. It appeared that bankers were being rewarded for recklessly tanking the economy. But it got the economy moving again. It also should be noted that the investments in the banks were fully recouped by the government, with interest.

The passage of the bailout package stabilized the stock markets, which hit bottom in March 2009 and then embarked on the longest bull market in its history.

Still, the economic damage and human suffering were immense. Unemployment reached 10%. About 3.8 million Americans lost their homes to foreclosures.

About Dodd-Frank

The most ambitious and controversial attempt to prevent such an event from happening again was the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. On the financial side, the act restricted some of the riskier activities of the biggest banks, increased government oversight of their activities, and forced them to maintain larger cash reserves. On the consumer side, it attempted to reduce predatory lending.

By 2018, some portions of the act had been rolled back by the Trump Administration, although an attempt at a more wholesale dismantling of the new regulations failed in the U.S. Senate.

Those regulations are intended to prevent a crisis similar to the 2007-2008 event from happening again.

Which doesn’t mean that there won’t be another financial crisis in the future. Bubbles have occurred periodically at least since the 1630s Dutch Tulip Bubble.

The Bottom Line

Bubbles occur all the time in the financial world. The price of a stock or any other commodity can become inflated beyond its intrinsic value. Usually, the damage is limited to losses for a few over-enthusiastic buyers.

The financial crisis of 2007-2008 was a different kind of bubble. Like only a few others in history, it grew big enough that, when it burst, it damaged entire economies and hurt millions of people, including many who were not speculating in mortgage-backed securities.