From Boom to Bust: Financial Crisis of 2008

Updated: Oct 17, 2016

Although academic interest in the global financial crisis that began in the United States in mid-2008 has declined as time goes on, it is a brief period in world economic history that is worth remembering and understanding. In many respects, the consequences of the crisis have become a way of life; while the world economy is slowly improving, the financial crisis fundamentally changed many economic relationships between governments, financial institutions, markets, and consumers.

From Boom to Bust in Six Easy Steps

The chain of events that explains the financial crisis is relatively simple. Naturally, each of these steps involved a large number of contributing factors. As the US economy improved after the “dot-com bubble” that created a short-term decline in 1999-2000, much of the recovery was directed into residential construction. In order to generate demand for the huge supply of housing, banks, and lending companies began issuing large numbers of “adjustable-rate mortgages”, mortgages with a low initial rate and with generally less stringent qualifications for buyers; this allowed a large number of people who had previously not been able to afford their own home a chance to buy one, and in many cases, spend more than was prudent for their level of income. The expansion of consumer credit in home loans also led to an increase in credit-funded consumer spending in other parts of the economy as well, fueled in large part through loans against home equity; as long as demand for housing remained strong – which was encouraged by looser credit standards – home prices and property values remained high, and consumers could use that value as collateral for additional spending.

Eventually, the housing supply reached a saturation point, which under “normal” circumstances would have resulted in housing prices declining gradually until a supply-demand equilibrium was reached; this would have been partly achieved by lenders tightening lending standards and incrementally increasing interest rates to compensate for lower revenues. Three things made the situation beginning in late 2005 less than “normal,” however:

1. The lending business had expanded along with the housing market
Because the demand for mortgages was roughly equal to the demand for houses, a large number of lending businesses – most operating under regulatory guidelines that were much less strict than for banks – were started after 2000. The problem this caused was a lack of funding; mortgages take a little time, from the perspective of the lender, to start providing a stable revenue stream that can be used for new loans, unless the lender has a large initial financial reserve, which many did not. That led to the growth of creative funding concepts, such as...

2. Mortgage-backed securities, which became a hot market commodity
In order to fund the lending boom, large and small lenders alike bundled their outstanding mortgages into financial derivatives called mortgage-backed securities, which took a variety of forms. An MBS is essentially a claim on a percentage of the cash inflow from a mortgage or group of mortgages and is generally paid on a monthly or quarterly basis, similar to a bond coupon. Once an MBS is created, however, its value as a tradable security is not necessarily limited to the expected revenue on paper from the mortgages in the pool; prior to 2008, the market value of these derivatives grew to several trillion dollars, many times the value of the properties they represented. The volatility of these MBS derivatives was a significant trigger for the financial disaster, because...

3. MBS were traded worldwide, meaning that US conditions were underliers for the entire global financial system
The drop in home prices, which was an inevitable consequence of a saturated market, led to lower revenues for lenders, which began to reduce the value of MBS’s. This created one self-feeding cycle because it led to less financing for new mortgages; it led to another because the only way the lenders could compensate was to raise the interest – sometimes precipitously – on their adjustable-rate mortgages, which in turn led to an accelerating number of mortgage defaults by borrowers. A mortgage that is not being paid has zero value as part of an MBS; in what seemed to be overnight but in reality was a period from late-2006 to mid-2008, an enormous amount of asset value held by financial institutions in the form of mortgage-backed securities simply vanished.

The impact on financial institutions meant that, at a minimum, lending became severely restricted, and a large number of institutions failed outright – 25 in the US in 2008 alone. The evaporation of the credit market impacted business and consumer spending and created the deepest recession in the US since the Great Depression of the 1930’s. Financial institutions overseas were not spared, either; large organizations such as the UK’s Northern Rock, Switzerland’s UBS, and the Royal Bank of Scotland were deeply exposed to the crisis through the MBS trade, and had to resort to various levels of government intervention to prevent utter chaos. The MBS problem affected a large number of investment organizations as well, companies and government bodies who held a large number of derivatives as part of the financial portfolios for pensions and retirement savings for workers.

The history of the financial crisis is mainly a lesson about the complex – and evidently potentially-risky – connections in global economics. The entire world economy suffered because of an unsustainable condition in the housing market in the US, and the financial products and processes that evolved as a result of that condition. Moves by governments toward better regulation of financial industries, such as the new requirements for financial reserves that will be required under the Third Basel Accord, have largely been aimed at providing firewalls to prevent future financial crises from spreading as far and as fast. In another respect, however, the history of the financial crisis serves as a warning of what can go wrong. In this context, we may find ourselves with some reasons to worry; in some parts of the world such as China and developing Asian countries, rapid expansion of real-estate markets threatens to reach the same “bubble” levels as what occurred in the US, and financial markets are beginning to see the reintroduction of exotic derivative securities. Knowing how quickly things can spiral out of control might help to prevent or at least lessen the effects of future financial crises.


 

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