INVESTING MARKETS

The 2007–2008
Financial Crisis in Review
By MANOJ SINGH Updated September 18, 2022

Reviewed by MARGUERITA CHENG

Fact checked by PETE RATHBURN

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, [1] BNP Paribas was warning investors
that they might not be able to withdraw money
from three of its funds, [2] and the British bank
Northern Rock was about to seek emergency
funding from the Bank of England. [3]

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.

KEY TAKEAWAYS
The 2007-2009 financial crisis developed
gradually. Home prices began to fall in
early 2006.
In early 2007, subprime lenders began to
file for bankruptcy.
In June 2007, two big hedge funds failed,
weighed down by investments in
subprime loans.
In August 2007, losses from subprime loan
investments caused a panic that froze the
global lending system.
In September 2007, Lehman Brothers
collapsed in the biggest U.S. bankruptcy
ever.
When the bubble burst, financial
institutions were left holding trillions of
dollars worth of near-worthless
investments in subprime mortgages.

What Caused the 2008

Financial Crisis?
The 2008 financial crisis began with
cheap credit and lax lending standards
that fueled a housing bubble. When the
bubble burst, the banks were left holding
trillions of dollars of worthless
investments in subprime mortgages. The
Great Recession that followed cost many
their jobs, their savings, and their homes.

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The 2007-08 Financial Crisis In Review

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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.

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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. [4] [5] The aim was
to boost the economy by making money available
to businesses and consumers at bargain rates.

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The result was an upward spiral in home prices as

borrowers took advantage of the low mortgage
rates. [6] 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. [7]

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. [5]

There were early signs of distress. By 2004, U.S.

homeownership had peaked at 69.2%. [8] Then, in
early 2006, home prices started to fall. [9]

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.

Important: Subprime mortgage

company New Century Financial made
nearly $60 billion in loans in 2006,
according to the Reuters news service.
In 2007, it filed for bankruptcy
protection. [10]

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. [11]

By June, Bear Stearns stopped redemptions in two

of its hedge funds, prompting Merrill Lynch to
seize $800 million in assets from the funds. [12]

Even these were small matters compared to what

was to happen in the months ahead.

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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.

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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. [13]

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. [5]

The bad news continued to pour in from all sides.

In February, the British government was forced to
nationalize Northern Rock. [14] 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. [15]

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., [16]
and the country's two biggest home lenders,
Fannie Mae and Freddie Mac, had been seized by
the U.S. government. [17]

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Yet the collapse of the venerable Wall Street bank

Lehman Brothers in September marked the largest
bankruptcy in U.S. history, [18] 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. [19]

Cost of the 2008 Financial Crisis

Bear Stearns
Fannie and
Bailout ($30B)
Freddie
Bailout
($187B)

Total:
$1,488B
ARRA Tax Cuts
TARP Bank
and Spending
Bailout
($831B)
($440B)

Source: Congressional Budget Office

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.

Important: The amount spent by the

government through the Troubled Asset
Relief Program (TARP). It got back
$442.6 billion after assets bought in the
crisis were resold at a profit. [20]

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. [21]

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. [22]

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. [23]

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.

FAST FACT
The 2007-2008 financial crisis was a
global event, not one restricted to the
U.S. Ireland's vibrant economy fell off a
cliff. Greece defaulted on its international
debts. Portugal and Spain suffered from
extreme levels of unemployment. Every
nation's experience was different and
complex.

What Is a Mortgage-Backed Security?

A mortgage-backed security is similar to a bond. It

consists of home loans bundled together and sold
by the banks that lend the money to Wall Street
investors. The point is to profit from the loan
interest paid by the mortgage holders.

In the early 2000s, loan originators encouraged

millions to borrow beyond their means to buy
homes they couldn't afford. The loans were then
sent on to investors in the form of mortgage-
backed securities.

Inevitably, the homeowners who had borrowed

beyond their means began to default. Housing
prices fell and millions walked away from
mortgages that cost more than the house was
worth.

Who Is to Blame for the Great

Recession?
Many economists place the greatest part of the
blame on lax mortgage lending policies that
allowed many consumers to borrow far more than
they could afford. But there's plenty of blame to
go around, including:

The predatory lenders who marketed

homeownership to people who could not
possibly pay back the mortgages they were
offered.
The investment gurus who bought those bad
mortgages and rolled them into bundles for
resale to investors.
The agencies who gave those mortgage
bundles top investment ratings, making them
appear to be safe.
The investors who failed to check the ratings,
or simply took care to unload the bundles to
other investors before they blew up.

Which Banks Failed in 2008?

The total number of bank failures linked to the
financial crisis cannot be revealed without first
reporting this: No depositor in an American bank
lost a penny to a bank failure.

That said, more than 500 banks failed between

2008 and 2015, compared to a total of 25 in the
preceding seven years, according to the Federal
Reserve of Cleveland. [24] Most were small regional
banks, and all were acquired by other banks, along
with their depositors' accounts.

The biggest failures were not banks in the

traditional Main Street sense but investment
banks that catered to institutional investors. These
notably included Lehman Brothers and Bear
Stearns. Lehman Brothers was denied a
government bailout and shut its doors. JPMorgan
Chase bought the ruins of Bear Stearns on the
cheap.

As for the biggest of the big banks, including

JPMorgan Chase, Goldman Sachs, Bank of
American, and Morgan Stanley, all were, famously,
"too big to fail." They took the bailout money,
repaid it to the government, and emerged bigger
than ever after the recession.

Who Made Money in the 2008 Financial

Crisis?
A number of smart investors made money from
the crisis, mostly by picking up pieces from the
wreckage.

Warren Buffett invested billions in companies

including Goldman Sachs and General Electric
out of a mix of motives that combined
patriotism and profit.
Hedge fund manager John Paulson made a lot
of money betting against the U.S. housing
market when the bubble formed, and then
made a lot more money betting on its recovery
after it hit bottom.
Investor Carl Icahn proved his market-timing
talent by selling and buying casino properties
before, during, and after the crisis.

The Bottom
TABLE Line
OF CONTENTS

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.

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