Crash of 2008

This article presents preliminary accounts of the sequence of events leading to the 2007-2008 financial crisis, of rival explanations for the crisis, of possible contributory factors, and of proposed remedies.

A detailed account of the sequence of events is set out on the Timelines subpage, together with links to contemporary news reports. Terms shown in brackets in the text are defined on the Related Pages subpage.

The crisis

The outcomes of the 2007-2008 financial crisis included the failure of many of the world's investment banks and the development of a "credit crunch" following the 2007 interbank market collapse - after which loans were refused to many who had hitherto been considered welcome borrowers, and significantly increased interest rates were charged to others. It developed into a threat to the continued existence of many financial markets and to a consequent loss of consumer and business confidence. The sequence of events that led to those outcomes is well documented but there is, as yet, no consensus concerning causes or remedies.

Background

In 2007, around 1.7 million properties were subject to foreclosure, many as a result of the subprime mortgage market. Also in 2007, a run occurred on the British bank and mortgage lender Northern Rock, an event not seen since the days of the Great Depression and other periods of economic downturn. In Feburary 2008, the British government bought Northern Rock.

In 2008, a number of other large banks have either gone out of business or have been sold: Lehmann Brothers declared bankruptcy in September 2008, and Merrill Lynch merged with the Bank of America in a deal worth $50 billion. The stock price of the insurance company American International Group fell 60% in one day. In the United Kingdom, Bradford & Bingley was nationalized, and other large financial companies are being nationalized all across Europe.

Explanations

A widely-held explanation of the crisis treats it as a fallout from the United States subprime mortgage crisis. For example, the explanation offered in September 2008 by the United States government can be summarised as follows.

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 .

An alternative put forward by a former member of the Bank of England's monetary policy committee, portrays the crisis as " an accident waiting to happen" that was triggered by the subprime crisis, but could have been triggered by any of a variety of events. His alternative explanation can be summarised as follows.

International organisations including the International Monetary Fund, and the Bank for International Settlements, and most central banks had long been warning about a serious underpricing of risk throughout the financial system. A general belief had arisen among bankers that if their bank got into trouble, their central bank would see it as a threat to the system and act to protect them from losses. Measurement difficulties may also have resulted in mistaken risk assessments by banks and their regulators. The failure of banking regulators to take action to avert the resulting danger may have been because they lacked the necessary regulatory instruments, or it may have been due to a lack of will. Central banks would have been reluctant to take corrective action by reducing their base rates because such action might confict with action to combat inflation. .

This explanation thus attributes the crisis to a variety of possible causes, including shortcomings of the regulatory systems, management failures by investment banks, and the conduct of banking regulators. Neither explanation excludes the possibility that the severity of the eventual crisis might have been increased by factors other than those held to be directly responsible. While it is too soon to expect the emergence of a consensus concerning their relative influence, there is already general agreement concerning the identification of possible contributory factors.

Contributory factors

Regulation

The fact that banks' assets, (which consist mainly of loans) amount typically to twenty times the value of their shares, makes 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 that multiple 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 banking 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. There followed a widespread restructuring of national financial systems and that was followed by a series of banking crises . A study for the Bank for International Settlements later concluded that financial liberalisation had left Spain, Norway, Sweden and the United States with regulatory systems that had been ill-prepared for the banking crises that they then encountered .

In 1974 the governors of the G10 central banks had set up The Basel Committee for Banking Supervision to coordinate precautionary banking regulations , and in 1988, concern about the increased danger of systemic failure led that committee to publish a set of regulatory recommendations that which related a bank's required reserve ratio to the riskiness of its assets . In 1999 further concern about the danger of instability led to the creation of the Financial Stability Forum to promote information exchange and international co-operation in financial supervision and surveillance. In 2004 the Basel Committee published revised recommendations known as Basel II intended to provide an improved accounting for investment risks in setting reserve requirements.

Other financial institutions are regulated by national authorities, including the Securities and Exchange Commission in the United States, and the Financial Services Authority in the United Kingdom. Until recently, however, restricted-membership hedge funds have escaped regulation, and those that are registered offshore continue to do so.

Financial innovation

Among major changes in banking practice that have developed since deregulation have been the growth of securitisation, enabling loans to be treated as assets comparable to tradeable bonds, and of the strategy known as "originate and distribute", under which banks originate loans and convert them into securities that they sell to other financial institutions such as pension funds and insurance companies. The distributed securities leave the originating banks' balance sheets and often escape regulatory requirements, but they are often transfered to hedge funds and structured investment vehicles that are themselves controlled and guaranteed by the originating banks.

A longer-term development has been a gradual change in the funding of banks' financial assets, away from liquid assets such as short term government bonds to private sector assets such as residential mortgages, and there has been a more recent trend toward the use of short-term interbank and money market borrowing to fund long-term loans.

A parallel development has been a massive expansion of hedge funds - to the point at which they are estimated to have accounted by 2005 for 40 to 50 per cent of daily activity on the London and New York stock exchanges . There are now many different types of hedge funds, but many of them deal in high-risk, high-return investments and some of them adopt high levels of leverage, using borrowed money amounting to over twenty times their capital.

Attitudes to risk

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' off-balance sheet vehicles that would result from an economic downturn, and the banks had underestimated the risks arising from their commitment to those vehicles. That had been due partly to the use of standard risk-management tools that were unsuitable for the assessment of securitised products when under stress, partly to difficulties of access to information, and partly to financial incentives to fund managers that failed to take account of inadvisable risk-taking.

The subprime mortgage crisis

Serious problems in the United States subprime 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 mortgages 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. An early sign of distress in the financial markets was the reported burden placed upon the Bear Stearns investment bank in June 2007 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. In July, two highly-respected credit rating agencies (Moodys and Standard and Poor) downgraded hundreds of subprime mortgage-backed securities - often by two or three rating categories, and commenced a review of their rating methods. A rumour circulated that higher-grade tranches were also affected and the mood of uncertainty spread from the subprime market to affect the markets for all types of asset-backed securities.

Consequences

The credit crisis

On 9th August 2007, a French investment bank, BNP Paribas, suspended withdrawals from three of its hedge funds , explaining that it had become impossible to value their securitised mortgage-backed assets fairly "regardless of their quality or credit rating". That announcement was immediately followed by the virtual closure of the interbank markets. Banks that had relied upon that source for short-term funding found themselves in difficulties. An early victim was the UK's Northern Rock which had relied upon those sources for 80 per cent of its funding. It was supported by short-term loans from the Bank of England, but news of that support panicked its depositors and provoked a traditional "run on the bank" as they rushed to withdraw their deposits. The crisis was further aggravated by banks' attempts to restore their reserve ratios after global capital writeoffs of about $500 billion, and by the middle of 2008 it was being said that "everyone wants to borrow and no-one wants to lend". In September 2008 a further source of credit dried up as the money market took fright after suffering losses from the bankruptcy of Lehman Btothers. Commercial companies other than banks came to be affected with the abandonment of the practice of rolling over maturing loans; and, by September, even major firms such as AT&T were finding it impossible to sell commercial paper with maturity longer than a day. Prospective householders were also affected as mortgage approvals plummetted.

Economic costs

It will be difficult to distinguish the economic consequences of events in the financial markets from those of the markets for food and fuel, but there can be no doubt that they made matters worse. It can be argued that fall in house prices was no more than the end of a speculative bubble, but it is safe to assume that it hastened the process. The full story is unlikely to become apparent until 2010 at the earliest, but the major falls in investor, consumer and business confidence that occurred throughout the developed economies in 2008 prompted forecasts of substantial reductions in economic growth in all developed economies.

Remedies

Rescue

In the early stages of the crisis, the responses of governments and financial regulators were influenced by reluctance to reinforce the moral hazard under which the expectation of rescue had encouraged risk-taking. Where very large financial institutions were concerned, however, that consideration was often outweighed by fear of "systemic failure", and that fear eventually became the dominant influence on policy. Early policy changes included a relaxation of the conditions and terms of routine short-term loans from central banks' discount windows, and the more liberal exercise of their emergency powers to act as "lenders of the last resort" . Later measures included support to the money markets by the United States Government, widespread attempts to restore general levels of financial liqiudity and provision of additional capital to a series of failing banks. But towards the end of September it became evident to the United States authorities that it would not be sufficient to improve liquidity, nor to continue with ad hoc bank rescues. After initial misgivings, the Congress came to accept that the restoration of confidence depended upon the wholesale removal of "toxic assets" from the financial system, and on 3rd October it approved the "Paulson Plan" which gave the Treasury the necessary powers. Also in early October, several countries extended existing depositor protection undertakings to provide for one hundred per cent compensation, and others were expected to follow suit.

Reform

Attempts to establish the causes of the crisis and to agree about appropriate remedies may be prolonged, but some contributions are already available. In April 2008 the Financial Stability Forum attributed the crisis to shortcomings in underwriting, firms'risk management practice, investor diligence, credit agencies' performance, staff incentives, disclosure practices, feedbacks between valuation and risk-taking, and regulatory effectiveness. They recommended regulatory changes under the headings of: strengthened prudential oversight of capital, liquidity and risk management, enhanced transparency and valuation, changes in the roles and uses of credit ratings, strengthening of the authorities’ responsiveness to risks, and robust arrangements for dealing with stress in the financial system.

References

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