Crash of 2008
|Supplements to this article include an annotated chronology and a glossary.|
The "Crash of 2008" was triggered by widespread defaults by holders of American housing mortgages. Uncertainty among bankers concerning the effect of those defaults upon the value of their mortgage-based securities caused a banking panic which came to infect most of the world's financial system. It was the worst economic shock since the Great Recession. It was also a decisive challenge to the prevailing conviction that the financial system was inherently stable.
This article is the second of a series of contemporary accounts of financial and economic events and developments during the period from mid 2007 to the end of 2011.
The other articles are:-
- Subprime mortgage crisis - events surrounding the bursting of a house price bubble in the United States in mid 2007
- Recession of 2009 - global economic developments from mid 2007 to the end of 2010
- Great Recession - an overview of global financial and economic events between mid 2007 and the end of 2011.
|We are in the midst of a once-in-a century credit tsunami (Alan Greenspan in evidence to the House of Representatives Oversight and Government Reform Committee 23 October 2008 )|
After more than a decade of global financial stability and uninterrupted economic growth, the world economy has been seriously damaged by a banking crisis which started in 2007, infected financial institutions throughout the industrialised countries in the course of 2008, generated a credit crunch that deprived their industries of the financial support that they needed for continued growth, and threatened the continued prosperity of their inhabitants.
The first stage of the crisis started in mid 2007, following the bursting of an asset price bubble in the United States housing market. That fall in prices prompted mortgage holders to default on their contracts, reducing the value of banks holdings of mortgage-based bonds. Its outward sign was a large-scale downgrading of those bonds by the credit rating agencies. The consequent reduction in their assets led, in its second stage to a worldwide succession of bank failures and rescues. The third stage of the crisis was triggered by the unprecedented losses that the September 2008 failure of the Lehman Brothers bank inflicted upon lenders in the money market. Doubts about the financial integrity of trading partners led to a progressive fall in the volume of financial transactions, and the virtual closure of the money and interbank markets.
Throughout the second half of 2007 and the first three quarters of 2008, governments in the United States and Europe tried without success to stem the developing panic by ad hoc assistance to individual banks. The panic was eventually stemmed in October 2008 by announcements of national rescue measures as a result of which each country's "ad hoc" support to individual banks was to be augmented by "systemic" support to all of its banks. The systemic measures that were adopted included injections of capital, the acquisition of stock in selected banks, and the offer of guarantees on all bank lending,. Evidence from the interbank market reflects the reversal of the downward trend in confidence that followed those announcements, and suggests that they were just in time to avert a meltdown.
The crash was, at first, explained simply as a fallout from the United States subprime mortgage crisis. The official explanation that was initially put forward was that:
- "Inflows of money from abroad -- along with low interest rates -- enabled more United States consumers and businesses to borrow money. Easy credit -- combined with the faulty assumption that house prices would continue to rise -- led mortgage lenders there to approve loans without due regard to ability to pay, and borrowers to take out larger loans than they could afford. Optimism about prices also led to a boom in which more houses were built than people were willing to buy, so that prices fell and borrowers - with houses worth less than they expected and payments they could not afford - began to default. As a result, holders of mortgage-backed securities began to incur serious losses, and those securities became so unreliable that they could not be sold. Investment banks were consequently left with large amounts of unsaleable assets, and many failed to meet their financial obligations. Arrangements for inter-bank lending went out of use, and banks through out the world cut back upon lending".
It was subsequently accepted that there had been other factors at work. Charles Goodhart, a former member of the Bank of England's monetary policy committee, portrays the crisis as "an accident waiting to happen". He took the view that, had it not been was triggered by the subprime crisis, it could have been triggered by any of a variety of other events. International organisations including the International Monetary Fund, and the Bank for International Settlements, and most central banks had long been warning about what they saw as a serious underestimation of risks by the financial system. Raghuram Rajan of the National Bureau of Economic Research had drawn attention to an increased willingness to take risks that had been brought about by the deregulation of the banking system. Rewards based upon volume of funds under management had given rise to tendency for increased risk-taking by traders, herding behaviour had encouraged that tendency, and belief that their central bank would protect them from losses had encouraged complacency among managements. Also, a growing practice of concealing information relating to risks had increased the incidence of errors of risk assessment by banks and their regulators. Banking regulators had failed to avert the resulting danger, either because they lacked the necessary regulatory instruments, or because of a lack of will. Central banks may have been reluctant to take corrective action by reducing interest rates when that would conflict with action to combat inflation. On this view the underlying causes of the crisis were shortcomings of the regulatory systems, management failures by investment banks, and the conduct of banking regulators.
A more far-reaching reason for the crisis is implied by paper by William White of the Bank for International Settlements, written before the outset of the crisis. The paper drew attention to a number financial and other "imbalances" such as an historically low ratio of household saving and an historically high level overseas indebtedness on the part of the United States; and raised the possibility that their unwinding could cause a financial and economic crisis. It also drew attention to the possibility that financial deregulation can lead to financial instability as market participants and supervisors cope with unfamiliar circumstances. An implication of the paper was a possibility that the market system itself might be prone to episodes of instability. Such episodes had in fact been the subject of a little-noticed 1992 paper by Hyman Minsky on his financial instability hypothesis.
The crisis can be attributed to the underlying causal factors that make the financial system vulnerable to shocks (a matter that is discussed in the article on financial regulation). Alternatively - as in this article - it can be attributed to the combination of factors that was responsible for the shock that triggered it. It is unlikely that the crash would have occurred had any of four factors been absent. But for the deregulations of the 1980s, the banks would not have been permitted to undertake the acquisition of toxic debt - and but for the innovations of the following decades, management awareness would probably have enabled such debts to be avoided. Even in the presence of both of those factors, the crash might well have been avoided but for the risk-assessment errors that were made, and it would not, of course, have been triggered in the way it was had there been no subprime mortgage crisis. Other factors were probably not essential. The mistakes made by the credit rating agencies are thought not to have been a major factor because their shortcomings had been well known; and claims that the problem had been aggravated by the "mark-to-market" accounting convention are believed to be mistaken.
Banks' assets (which consist mainly of loans) amount typically to twenty times the value of their shares, making them especially vulnerable to falls in the value of those assets. Governments have long been aware of the danger that a loss of confidence following the failure of one bank could lead to the failure of others, and eventually to systemic failure of the entire financial system. To limit that danger, they have traditionally required banks to limit the extent to which their loans exceed the funds provided by their shareholders by the imposition of minimum reserve ratios and have placed various other restrictions upon their activities. In the 1980s, however, it was widely considered that those regulations were imposing excessive economic penalties, and there was a general move toward deregulation. Restrictions that had prevented investment banks from broadening their activities to include branch banking, insurance or mortgage lending were dropped, and reserve requirements were relaxed or removed.
Among major changes in banking practice that have developed since deregulation have been the growth of securitisation, meaning the conversion of their loans into graded packages of bonds; and increased use of the strategy known as originate and distribute under which such bonds were sold to pension funds, insurance companies and other banks. The latter procedure removed the loans from the originating banks' balance sheets (thus improving their reserve ratios), but continued to be their financial responsibility when – as often happened – they were transferred to their own hedge funds and to their specially-created structured investment vehicles.
A longer-term development has been a gradual change in the funding of lending, away from liquid assets that can be readily converted to cash, such as short term government bonds to private sector assets such as residential mortgages; also, there has recently been a hazardous trend toward increased leverage, and an increase in the use of short-term interbank market and money market borrowing to pay for long-term loans.
- (for an explanation of the importance to their stability of the banks' use of leverage, see leverage effect in the article on banking)
A parallel development was a massive expansion of the unregulated organisations known as hedge funds – to the point at which they are estimated to have accounted for 40 to 50 per cent of stock exchange activity by 2005 - many of which dealt in high-risk, high-return investments, and some of which used borrowed money amounting to over twenty times their capital.
By early 2007 the regulatory authorities were expressing increased concern about banking attitudes to risk According to the Financial Stability Forum, there had been an expansion "on a dramatic scale" of what they described as the "global trend of low risk premia and low expectations of financial volatility". In their view, both the banks and the rating agencies had underestimated the risks to the banks' hidden subsidiaries that would result from an economic downturn, and the risks to the banks arising from their commitment to those subsidiaries. Those risk management errors had been due partly to the use of risk-management procedures that had been developed from experience with conventional investment products under normal circumstances, but were unsuitable for the predicting the value and risk of securitised products in times of significant economic difficulties; partly to a lack of access to the detailed information needed to independently value them in an accurate way; and partly to an incentive structure for fund managers which in effect rewarded them for taking risks.
The subprime mortgage crisis
Serious problems in the United States mortgage market emerged in 2005, and arrears and defaults grew throughout 2006. By the end of 2006 it was estimated that over two million households had either lost their homes or would do so in the course of the following two years, and that one in five subprime mortgages that had been taken out in the previous two years would end in foreclosure. The origins and causes of those problems are described in the article on the subprime mortgage crisis. Their consequences for the financial system arose from their effects upon the holders of mortgage-backed securitised products. Those products had been divided according to risk into a range of "tranches", each of which had been sold to a different category of investor, with the riskiest usually going to hedge funds and others often going to pension funds and to banks' structured investment vehicles. Early signs of crisis in the financial markets were the reports of problems at the government-sponsored enterprises (Fannie Mae and Freddie Mac) and at several of the major US banks. In June 2007, the Bear Stearns investment bank was placed in severe difficulties by the need to rescue two of its hedge funds. By that time it was clear that the US housing boom had ended, and with falling house prices, there were accelerating mortgage foreclosures. A rumour circulated that, in addition to tranches of securitised subprime mortgages, higher-grade tranches were also affected, and the mood of uncertainty spread from the subprime mortgage market to affect the markets for all types of asset-backed securities.
Credit rating errors
Among the principal causes of the crash according to a presidential working group were flaws in the credit rating agencies' assessments of subprime residential mortgage-based securities, and a congressional inquiry brought to light risk assessment errors in their rating methods that prompted its chairman to describe their performance as a "colossal failure". Those statements suggest that the credit rating agencies must bear a major responsibility for the investment errors that led to the crash, but a report of interviews with international investment managers attending a London workshop has thrown some doubt upon that conclusion. The investment managers were reluctant to blame the agencies for the crisis because their shortcomings had been well known, having been revealed by their poor performance in anticipating the Asian banking crisis, and there had also been general awareness of the conflict of interest created by the fact that the agencies' principal source of income was payment by the issuers of the investments that they rated. Nevertheless it was thought likely that the wider - and less well informed - body of investors had been strongly influenced by mistaken ratings. The study group that reported on the interviews concluded that - although there had been other important reasons for their risk-management errors - credit ratings had exerted a significant influence on investors' decisions, and that they had played an important part in the marketing prospectuses of the issuers of mortgage-backed securities.
"Mark to market" accounting
Despite the widely held belief that problems applying the mark to market form of fair value accounting to illiquid assets had aggravated the financial crisis, a study by the staff of the United States Securities and Exchange Commission concluded that it had not been a major factor in either the bank failures or the crisis at other financial institutions, such as Bear Stearns, Lehman and AIG. The authors considered that liquidity pressures brought on by poor risk management and "concerns about asset quality" had been the predominant factors. The theoretical possibility that mark market accounting could lead to financial instability had been demonstrated by Professor Hyun Song Shin in a 2008 lecture.
Although the decline in confidence in the financial system was arrested in October 2008, its continuing recovery some fifteen months later was still considered to be "fragile". By 2010, the cumulative balance sheet loss that had been incurred by the global banking system was estimated to have reached $2.3 trillion. Bank balance sheets still contained bad assets, and much of the financial system continued to rely upon the rescue measures that had been introduced in 2008..
The real economy was seriously damaged as a result of attempts by banks holding toxic mortgage-based securities, to deleverage their balance sheets. Business and personal loans were restricted, creating a credit crunch. The practice of routinely "rolling over" maturing loans was largely abandoned, and even major firms such as AT&T found it impossible to borrow money by selling their commercial paper if it was repayable after periods longer than a day. Prospective householders were also affected as mortgage approvals plummeted. The immediate consequence was an economic downturn that was to develop into the worst recession since the second world war.
|Further developments are described in the article on the recession of 2009|
- Lehman Brothers Holdings Inc. Chapter 11 Proceedings Examiner’s Report, 2010,
- Public Policy Issues Raised by the Report of the Lehman Bankruptcy Examiner, Hearing by the United States House of Representatives Financial Services Committee, April 20, 2010
- "A chronology of policy responses to the financial market crisis", Appendix A.1A, OECD Economic Outlook, December 2008
- Summarised from President Bush's television address of 25 September
- Charles Goodhart: "Explaining the Financial Crisis", Prospect, February 2008 (based on a paper prepared for The Journal of International Economics and Economic Policy, Vol 4 No 4)
- Raghuram Rajan: Has Financial Development Made the World Riskier? , Working Paper No 11728, National Bureau of Economic Research September 2005
- William White:Procyclicality in the Financial System: do we need a new macrofinancial stabilisation framework?,BIS Working Paper No 193, Bank for International Settlements, January 2006
- Hyman Minsky: The Financial Instability Hypothesis, Working Paper No. 74, The Jerome Levy Economics Institute of Bard College, May 1992
- Financial Stability Report, Chart 1.9, Page 9, Bank of England, October 28 2008
- Financial Stability Report, p36, Bank of England April 2007
- Financial Risk Outlook 2007, Financial Standards Authority January 2007
- Financial Stability Report, Bank of England April 2007
- Raghuram Rajan: Has Financial Development Made the World Riskier? , Working Paper No 11728, National Bureau of Economic Research September 2005
- Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience, International Monetary Fund 5th February 2008
- 2006 Report of the Center for Responsible Lending (quoted in the 6th report of the House of Commons Treasury Committee Session 2007-8, par 74 
- Financial Stability Report, pages 18 and 19, Bank of England, October 28 2008
- Mortgage Foreclosures April 2007 to August 2008, The Numbers Guru, September 2008
- The evidence on which this paragraph is based is set out in detail in paragraphs 73-80 of 6th report of the House of Commoms Treasury Committee Session 2007-8,  and the Bank of England's October 2008 Financial Stability Report 
- Policy Statement on Financial Market Developments, by The President's Working Group on Financial Markets, March 2008
- Hearing on the Credit Rating Agencies and the Financial Crisis, Committee on Oversight and Government Reform, United States House of Representatives, October 22 2008
- "Ratings in Structured Finance: what went wrong and what can be done to address shortcomings? , Section 3, (Industry views) SCGFS Report No 32, Committee on the Global Financial System, Bank for International Settlements, July 2008
- Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting, United states Securities and Exchange Commission, 2009
- Hyun Song Shin: Risk and Liquidity, Clarendon Lectures in Finance, Chapter 1, Oxford University Press, 2009
- IMF Global Stability Report, April 2010