The Financial Crisis of 2007-2009, or the Global Financial Crisis, came as a shock to many bankers, policymakers, and regulators, who in many cases did not believe that a crisis of this scale was possible in modern capitalist economies. The crisis triggered a deep recession in countries across the globe, known as the Great Recession, which caused aggregate Global GDP growth to enter negative territory for the first time since records began. The turmoil in financial markets and the subsequent need for government bailouts to stabilize economies led to an increase in criticism of financial institutions and calls for greater banking regulation. The reaction of central banks across the globe to the crisis was significant in demonstrating that policymakers were willing to do “whatever it takes” to stabilize markets and return business confidence, whether that be through swap lines between central banks, historically low interest rates, or through unconventional monetary policy measures such as quantitative easing.
Wall Street and the ‘Great Moderation’
Wall Street, the center of U.S. and global finance in New York City, had experienced several decades of growth up until 2007. While in the period from the end of World War II until the 1970s a much more regulated system of global finance had been created, known as Bretton Woods, policymakers in most advanced economies during the 1970s had begun to deregulate their banking systems, lower capital controls, and to allow for greater multinational activity of financial institutions. Before this, the banking industry had been a highly regulated sector, while afterwards it became much easier for financial institutions to expand leverage and engage in new ventures. This new ‘liberalized’ environment allowed for a great number of new financial products, contracts, and other innovations to proliferate. A particularly notable trend was the emergence of non-bank financial intermediaries (NBFIs), or shadow banks, which performed some of the lending and intermediation functions of regular banks but with much less government regulation. These NBFIs would become heavily implicated in the frenzy of activity related to mortgage derivatives, which was a key cause of the financial crisis.
This period of growth on Wall Street from the mid-1980s onwards was also a time of remarkable macroeconomic stability in the United States. Ben Bernanke, later the chairman of the Federal Reserve during the financial crisis, christened this era "the Great Moderation" in 2004, pointing to the combination of low inflation rates and stable real GDP growth in the U.S.. Macroeconomic stability came at the same time as what has been called the 'Washington Consensus' - the spread of free-market, liberal economic ideas across the globe, particularly championed by U.S.-based international economic institutions, such as the World Bank and the IMF, as well as by the U.S. Treasury. The combination of a stable domestic economy and expanding global markets in which to trade, led to a sense of economic optimism which, even after the 'Dot Com' crash of 2001, propelled the U.S. economy to new heights. In hindsight, economic commentators have reckoned that market participants, particularly those in the U.S. housing market, were far more optimistic than the fundamentals of the U.S. economy gave them cause to be. This 'irrational exuberance', whereby investors were caught up in the mania caused by consistently rising asset prices, would come to a sobering end when the U.S. housing bubble began to burst towards the end of 2006.
U.S. housing bubble
The most consequent of the innovations on Wall Street for the financial crisis was the mortgage-backed security (MBS), a derivative product which effectively allowed banks to bundle regular residential mortgages together and then sell insurance on the risk of default. In theory, this product would allow for banks to almost entirely eliminate their exposure to risk through housing loans, meaning that they could expand their balance sheets and offer credit to more prospective house buyers. These MBSs were quickly extended to include ‘subprime’ mortgages, or mortgages which were offered to customers who under regular circ*mstances would not be able to access the credit needed to buy a house. This ‘subprime’ category was encouraged by the U.S. government agencies Fannie Mae and Freddie Mac, institutions set up to help U.S. consumers to buy houses by extending liquidity to banks. With government support thought to be preventing the market from crashing, many financial institutions became caught up in the ‘irrational exuberance’ of the bubble, extending credit far past what was prudent and ignoring best practice in lending.
These MBSs and other related complex financial products had a secondary use, in that they were used by financial institutions as collateral when trading with each other. As credit ratings agencies had assured participants that most of these products were of the highest quality, regardless of the type of loans included in the products, they were assumed to be “as good as gold” and traded in large quantities. This use of the derivatives further increased the incentive of banks to extend mortgage credit, creating a vicious cycle. U.S. workers, many of whom were not seeing their wages grow in real terms, often saw home ownership as a way to build wealth and to chase the "American dream". These workers were in many cases sold housing loans by predatory mortgage brokers, who worked on commission and therefore had incentive to maximize the number of mortgages sold, regardless of the risk involved. These factors began to coalesce to form a “perfect storm” in the financial sector as the U.S. economy and housing market began to slow in 2006 and 2007.
Escalating crisis and the collapse of Lehman Brothers
The slowdown in the real estate sector began to cause tremors in financial markets during the Summer of 2006, with BNP Paribas, one of Europe's largest banks, stopping withdrawals from some of its funds on August 9, due to an inability to value their holdings of U.S. mortgage-backed securities. As the bubble began to burst, the number of willing buyers of MBS products dried up, revealing that many of these derivatives had been vastly overvalued and given fraudulent ratings by credit ratings agencies. Many financial institutions now wanted to dispose of their positions in subprime MBS as quickly as possible. The need for this 'fire sale' was amplified by the fact that some financial market actors had built huge 'short' positions in the market for MBS, meaning that as mortgage defaults rose, the parties which held the MBS had to pay out increasing amounts. The financial sector was experiencing a loss spiral and a self-reinforcing cycle of fear, whereby participants in financial markets were adjusting their portfolios in order to shield themselves from losses, but these shifts were in fact amplifying the effects of the crisis and resulting in further losses.
The feedback loop was quickly spiraling out of control, as some of the world's largest financial institutions came under extreme financial distress. A critical issue was that due to the "too big to fail" nature of these institutions and their interconnected balance sheets, if one bank was to fail, it could trigger the collapse of almost the entire industry. Bear Stearns, one of Wall Street's largest investment banks, was able to be bought by J.P. Morgan Chase with the assistance of the Federal Reserve in March of 2008. No such buyer could be found for Lehman Brothers, however, and the firm collapsed on September 15th, finally triggering the global financial panic which had been building for the previous year. The next day, September 16, the Federal Reserve was forced to step in to prevent the failure of AIG, the country's largest insurance company. Policymakers now realized that if they did not backstop the entire U.S. financial system, there could be a complete meltdown. As Federal Reserve chairman Ben Bernanke is reported to have said "if we don't do this, we may not have an economy on Monday".
Policy responses and legacies of the crisis
The interventions the Federal Reserve and U.S. Treasury made in the financial system following Lehman's collapse were unprecedented in U.S. history. Prior to Lehman, the administration of President George W. Bush had been reluctant to interfere directly in the sector, preferring instead to try to broker sales of troubled institutions with the assistance of the Fed. As the scale of the crisis on Wall Street became clearer, however, Treasury Secretary Henry Paulson led the government's effort to avoid a crisis of the scale of the Great Depression. Congress approved Paulson's bailout package for the financial sector, the Troubled Asset Relief Program (TARP), which allocated 700 billions U.S. dollars for stabilization purposes. The Fed lowered its key interest rate close to zero percent in November 2008, keeping it there until 2016. The policy of quantitative easing was introduced in 2008 to relieve stress from financial institutions by taking assets off their balance sheets, thereby injecting liquidity into the system. This policy led to a quadrupling of the size of the Fed's balance sheet by the mid-2010s.
While the interventions into the financial system were effective in preventing the collapse of further systemically relevant financial institutions, the crisis spread from the financial to the real economy in late 2008. The subsequent economic downturn, known sometimes as the Great Recession, resulted in tens of million of people being made unemployed, tens of thousands of bankruptcies, and millions of mortgage foreclosures. While the recession would technically last 18 months, the longest recession since the Great Depression, its effects were felt both in the U.S. and globally for many years afterwards. The financial crisis is seen as having overturned decades of complacency towards the risks which financial instability can pose for the economy. The Basel III banking regulations were created in the aftermath of the crisis to strengthen oversight of the financial sector, although public opinion still strongly sides with the view that post-crisis regulation did not go far enough.
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