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Lehman Brothers. Photo by Jorge Royan.

Top 10 Facts about The Financial Crisis of 2007鈥�08

After the Great Depression of 1929, the financial crisis of 2007-2008, was arguably the worst economic disaster of a similar magnitude to have since hit the world.

Even though the Federal Reserve and the U.S. Department of the Treasury put in place a lot of measures to forestall the crisis it nevertheless still happened.   

During the crisis, the housing prices dropped more than the prices plunge during the Great Depression creating what is now called the Great Recession.

Big financial institutions such Lehman Brothers went bankrupt and collapsed while others like Bear Stearns were take over at a throw away price.

The Great Recession of 2007-2008 was so severe that, unemployment was still above 9% even after it ended.

The   top 10 facts about the Financial Crisis of 2007鈥�08 include the following.

1. The Subtle Signs of The Financial Crisis of 2007-2008 Started In 2006

The subtle signs of the financial crisis of 2007-2008 began in 2006 when housing prices started to fall after decades of real estate boom.

Different stakeholders in real estate expressed mixed reactions about the fall.

Realtors thought the overheated housing market would stabilize after sometime and hence they applauded the fall.

However, realtors overlooked the fact that many homeowners had been advanced mortgage loans of up to 100% of their home鈥檚 value or higher while their credit rating was questionable.

Some people blamed Fannie Mae and Freddie Mac for causing the crisis as they guaranteed majority of the mortgages to people with questionable credit rating.

2. The Deregulation of Financial Derivatives Partly Caused the Crisis

One of the main underlying causes of the crisis was the deregulation of financial derivatives.

Deregulation of the financial system was precipitated by the passing of two laws. The two laws   permitted banks to invest in derivates that were related to real estate.

The returns from these real estate derivatives were so good that they encouraged banks to lend to borrowers with questionable credit rating to maximize returns.

One of the laws which allowed banks to use deposits to invest in derivatives was The Financial Services Modernization Act of 1999 also known as the Gramm-Leach-Bliley Act which President Bill Clinton signed into law.

Before the law was enacted, banks had promised that they intended to invest in low-risk securities. However, they failed to keep that promise as they chased the profitable derivative market.

Derivatives were exempted from regulatory oversight by the The Commodity Futures Modernization Act.

State regulations on the derivatives market were therefore overruled.

3. Loose Lending Standards Created Subprime Mortgages

The residential housing market was booming by early to mid-2000s. Mortgage lenders rushed to approve as many home loans as they could to capitalize on the boom.

Many borrowers with poor credit rating were given mortgages by the mortgage lenders such as New Century Financial, Fannie Mae and Freddie Mac who were eager to capitalize on the housing boom. 

The mortgage loans issued to borrowers with less-than-ideal credit rating were risky loans called subprime mortgages.

Subprime mortgages were mortgage loans issued to borrowers who had low credit ratings either due to having dubious streams of incomes and or multiple dings on their credit history.

The loan verification process for these borrowers was so lax during the time that the loans were nicknamed 鈥淣INJA鈥� loans which referred to borrowers 鈥渘o assets, no job and no assets鈥� loans.

4. Subprime Mortgages Was One of The Main Causes of The Crisis

The subprime mortgages opened the market to a flood of new homebuyers who previously couldn’t qualify for conventional mortgages.

High demand for homes ensued in the market due availability of easy housing credit.

The rise in demand for homes led to an increase in housing prices which resulted in the formation of the housing bubble prior to 2006.

Subprime mortgages were adjustable-rate mortgages, which initially charged low, affordable payments and in the years thereafter charged higher payments.

The payments structure was enabled by the low interest rates which prevailed in the market at the time.

The risk of this payment structure on subprime mortgages was that borrowers were likely to default if interest rates suddenly rose because they had shaky financial footing.

Many homebuyers took on loans without knowing the risks involved in the rush to take advantage of a hot market and low interest rates.

Mortgage lenders and other stakeholders operated under the common wisdom that since real estate prices were sure to keep on rising they were safe.

A mortgage lender could foreclose on a homeowner who defaults and sell the home at a profit. The risk of loss appeared low at the time.

When interest rates started going up in 2006 and home prices fell, subprime mortgage borrowers found themselves unable to pay their loans and consequently defaulted.

The ripple effect was basically the genesis of the financial crisis of 2007-2008.

5. Risky Wall Street Behavior Exacerbated the Crisis

Stakeholders in the real estate industry created new ways to make money through hybrid derivative financial instruments.

Mortgage lenders packaged subprime mortgage loans in a process called securitization and resold them as mortgage-backed securities (MBS).

This was done in an effort to make more money off of the real estate industry in addition to issuing mortgages to maximize incomes from the real estate boom.

 Subprime lenders such as Fannie Mae and Freddie Mac bundled loans together through securitization and sold them to investment banks.

The Investment banks then sold the bundled loans as mortgage-backed securities (MBS) to investors around the world.

The investment banks such as Lehman Brothers eventually repackaged and sold the mortgage-backed securities as collateralized debt obligations (CDOs) on the secondary market eventually.

To suit different types of investors, each financial instrument combined multiple loans of varying quality into one product, divided into segments, or tranches, each with its own risk levels.

There was a theory that the variety of different mortgages reduced the CDOs’ risk and it was backed by elaborate Wall Street mathematical models.

However, the reality was that a lot of the tranches would drag down returns of the entire portfolio as they contained mortgages of poor quality.

Since financial markets seemed stable, investors felt secure about taking significant amounts of debt to buy CDOs at low short-term rates.

Banks used credit default swaps (CDS), another financial derivative, to insure against defaults on CDOs to make matters even more complicated.

The buying and selling of credit default swaps on CDOs are transactions that were unregulated and performed regularly by banks and hedge funds.

Investors couldn’t assess the actual risks banks and hedge funds assumed because CDS transactions were not disclosed on their balance sheets.

 The main reason why the financial crisis was so widespread was due to the convoluted jumble of financial products that included MBS, CDOs, and CDSs which created a domino-like collapse of the housing market.

6. The Financial Crisis Was Characterized by Weak Watchdogs

The MBS and CDOs required the blessing of credit rating agencies in order to be marketed to investors just like corporate bonds and other forms of debt.

Moody’s, S&P, and Fitch Group were the “Big Three” credit rating agencies during the financial crisis.

The “Big Three” credit rating agencies placed AAA ratings on many securities even though a significant portion of the securities contained highly risky loans in the form of subprime mortgages.

Usually AAA rating is reserved for the safest investments which the securities bundled together as MBS and CDOs could not meet had they been subjected to due diligence.

Even though the rating agencies were supposed to be independent, their independence was compromised as they were  paid by the same banks they were supposed to rate.

Conflict of interest therefore existed which compromised the independence of the rating agencies.  

7. The Financial Crisis Created A Credit Crunch

When interest rates rose, defaults on subprime mortgage payments skyrocketed.

Demand for homes fell and housing prices plummeted. The Mortgage-backed securities lost value.

Banks, hedge funds and other financial institutions which had acquired CDS to protect against default in CDOs and MBS made claims to insurance companies.

The American Insurance Group (AIG) which had underwritten the risk of most CDS didn’t have enough cash flow to honour all the swaps when the derivatives lost value.

Investments banks which had invested heavily in CDOs suffered massive losses. Investment bank Bear Stearns sold itself to JP. Morgan Chase for $10 per share to avoid bankruptcy.

Another investment bank Lehman Brothers whose $600 billion debt was covered by CDS of $400 billion collapsed, declaring bankruptcy on September 15^th since the debt was worth nothing by that time.

Banks panicked and stopped lending to each other once they realized they would have to absorb the losses created by the worthless derivative instruments.

The entire global banking system became short of funds since banks didn鈥檛 know who held the toxic assets i.e. the financial derivative assets contaminated by toxic assets

Interbank borrowing costs rose as banks didn’t want other banks to give them worthless mortgages as collateral.  There was a credit crunch in the market as a consequence of these moves.

8. The Impact of The Financial Crisis Was Unprecedented

It is estimated that the great recession caused by the financial crisis lasted for a period of 18 months.

The net worth of US households declined by an astronomical $19.2 trillion during the period.

The US gross domestic product (GDP) experienced the largest decline in the last 60 years as it fell by 4.3% during the period.

The overall unemployment rate reached 10% while the rates reached 15% and 12% among Black Americans and Hispanics respectively by October 2009.

In the period between July 2008 and March 2009 the US stock markets lost $7.4 trillion in stock wealth.

In 2009 and 2010 about three million home foreclosures were reported a year.

Large corporates declared Chapter 11 bankruptcy such as the New Century Financial, American Insurance Group and Lehman Brothers among others.

International trade and industrial production fell at an even a faster rate than during the Great Depression of the 1930s which led to unprecedented decline of the global economy.

Companies started massive layoffs and unemployment skyrocketed globally as consumer and business confidence was shattered

9. The Cost of The Crisis Was Astronomical

In March 2008 investors sold off their shares of investment bank Bear Stearns because it held many subprime mortgages. 

That action by investors marked the beginning of the 2008 financial crisis.

The US treasury had to provide a $30 billion guarantee to JP Morgan Chase to bail out investment bank Bear Stearns. In the summer of 2008, the situation on Wall Street deteriorated.

The Federal Reserve issued $85 billion to American Insurance Group as a bailout loan but it grew to $182 billion after restructuring in October and November 2008.

Treasury Secretary Henry Paulson   was authorized to take over mortgage companies Fannie Mae and Freddie Mac at a cost of $187 billion.

A $700 billion bailout package was submitted to Congress by Treasury Secretary Henry Paulson and Fed Chair Ben Bernanke.

10. The Financial Crisis Led to The Dropping of Big Financial Institutions

The CDO debacle turned into a full-blown credit crisis by the spring of 2008. 

Given all the packaging and repackaging of the CDOs, MBS and CDS, it was not clear which institution鈥檚 balance sheet harbored them.

Interbank lending stopped and where it happened it was at very high lending rates.

Big financial institutions started dropping one by one. Investment bank Lehman Brothers declared bankruptcy on 15^th September after it was found that CDSs were supposed to cover $400 billion of its $600 billion of debt.

The Dow Jones Industrial Index went into free-fall, declining 3,600 points as from September 19 to October 10, 2008; the sharpest reaction by the stock market to the crisis

Bank of America announced it was acquiring Merrill Lynch while the FDIC seized Washington Mutual.

The FDIC proceeded to transfer Washington Mutual鈥檚 assets to JPMorgan Chase. Before then Washington Mutual was the country’s largest in the savings and loan industry.

To obtain federal bailout Goldman Sachs and Morgan Stanley, the last two of the major still-intact investment banks, converted to bank holding companies.