Crash of 2008

The global financial crisis that may come to be known as "the Crash of 2008" was described by former Federal Reserve Bank Chairman Alan Greenspan as being a "once in a century credit tsunami" . It was triggered by the American subprime mortgage crisis, which infected much of the world's financial system and exposed its fragility. The credit shortage and general loss of confidence that followed contributed to the severity of the developing recession of 2009.

Governments in the United States and Europe have responded to the crisis by providing unprecedented amounts of financial support to their banking systems, and are considering measures to strengthen their regulation.

(for definitions of terms shown in italics in the following text, see the glossary on the Related Articles subpage.)

The crisis

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. That banking crisis was the result of making bad investments with borrowed money on a scale that was only made possible by a relaxation of regulation in the 1980s and a major increase in the complexity of the banks' investments in the following years. It was triggered by the bursting of what is generally held to have been a "bubble" in the United States housing market that started in 2005 and led, in the spring of 2007, to a downgrading of the banks' holdings of bonds based upon mortgages made in that market, and to a widespread loss of confidence in their financial solvency. Failures of Bear Stearns and other major banks in the Summer of 2007 made the survivors extremely reluctant to lend to each other, and the "money market", that had been their only other source of short-term borrowing, also dried up in the Autumn of 2008, following the unprecedent losses that the September failure of the Lehman Brothers bank inflicted upon its lenders. Deprived of those sources of finance, the remaining banks sought to hold on to what cash they had by severely limiting their loans to industries and prospective house buyers, leading in October to a widespread loss of confidence, and to cutbacks in spending for consumption and investment.

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 failing banks, but in October they found themselves forced to adopt general schemes of support to their entire financial systems by injections of capital, the acquisition of stock in selected banks, and the offer of guarantees on all bank lending, but confidence was slow to return, and the damage done was to lead to the recession of 2009.

(for a detailed account of the development of events in the United States housing market see the subprime mortgage crisis article; for a discussion of the risk-assessment mistakes that were made see the Tutorials subpage; and for a month-by-month and day-by-day listing of the sequence of events, with links to current news reports, see the Timelines subpage)

Explanations

A widely-held explanation of the crash 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 .

Among other explanations was that forward by Charles Goodhart, 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. 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 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" (which the author defined as significant and sustained deviations from historical norms) such as a 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 instablity. However, none of those explanations excludes the possibility that the severity of the 2008 crisis might have been increased by a number of factors other than those held to be mainly responsible.

The principal causative 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 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. In the following years there were major changes to banking practices, and they were followed by a series of banking crises . A study for the Bank for International Settlements later concluded that deregulation 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 central banks of the Group of Ten leading industrial countries 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 related a bank's required reserve ratio to the riskiness of its loans . 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 require banks to take more detailed account of the riskiness of their loans.

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.

(for an account of the development of banking regulation, see the article on banking)

Financial innovation

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 responsiblity when – as often happened – they were transfered 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 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 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 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.

(for more on changes in the practices of the finance industries see the article on the financial system)

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' hidden subsidiaries that would result from an economic downturn, and the risks to the banks arising from their commitment to those subsidiaries. That 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.

(for more on the risk management errors, see the Tutorials subpage and the Risk management article )"

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 deficiencies 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.

(for more on the credit rating errors, see the tutorials subpage )

"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 .

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 market to affect the markets for all types of asset-backed securities. .

(this topic is dealt with in more detail in the article on the subprime mortgage crisis)

Consequences

The credit crisis

On 9th August 2007, a French investment bank, BNP Paribas, suspended withdrawals from three of its hedge funds on the grounds that it had become impossible to value their mortgage-backed assets. That announcement was immediately followed by the virtual closure of the interbank markets that banks had used to borrow from each other. Banks that had relied upon that source for short-term funding found themselves in difficulties. An early victim was the UK's Northern Rock bank, 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 unprecedented losses from the bankruptcy of Lehman Brothers. 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 borrow money by selling their commercial paper that was repayable after periods longer than a day. Prospective householders were also affected as mortgage approvals plummetted.

(further developments on this topic are to be considered in the article on the financial system)

Economic costs

It may prove to be difficult to distinguish the economic consequences of the crash from those of the preceding trends in the markets for food and fuel, but there can be no doubt that it is making matters a great deal 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 downturn and added greatly to its severity. The full story is unlikely to become apparent for some years, but the major falls in investor, consumer and business confidence that occurred in 2008 prompted forecasts of substantial reductions in economic growth in all developed economies. But, although they consider that the scale of the financial crisis may well be broadly comparable with that of the (very different) crash of 1929 , most economists do not anticipate a recession as severe or prolonged as the Great Depression, on the presumption that the damaging policy responses of the 1930s will not be repeated

(an account of subsequent economic developments is available in the article on the recession of 2009)

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 liquidity and provision of additional capital to a series of failing banks.

Those proposals had little effect upon confidence and, 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 adoption of more coprehensive measures and on 3rd October it approved the $700 billion "Paulson Plan" which gave the Treasury the power (subsequently abandoned) to remove "troubled assets" from American banks. A few days later, the British Government announced a £500 billion rescue scheme , including powers to take equity stakes in ailing banks and an undertaking to guarantee interbank loans (that came to be known as the "Brown plan"); and a group of central banks announced a coordinated half per cent cut in their discount rates.

On October 10th the finance ministers of the "Group of Seven" leading industrial countries agreed a broadly-stated "action plan" but failed to state their intention in concrete terms. However, in a reversal of his former intentions, the United States Treasury Secretary subsequently indicated a willingness to extend the "Paulson Plan" to include the acquisition of equity in US banks , and, following a recommendation by Paul Krugman , plans were reported to have been set in motion to buy equity stakes in nine US banks. On the 12th of October, European Union leaders also agreed to pursue a rescue programme based upon the Brown plan, and on October 14th 2008, President Bush formally announced plans both to purchase equity in US banks, and to guarantee their loans , which was followed by some tentative signs of recovery in the interbank and money markets.

(an account of the subsequent development and implementation of rescue plans is to be included in the article on bank failures and rescues).

Reform

A crippling of the world financial system that was triggered by a minority of defaults in a small corner of the United States economy has been seen as an reminder of that system's inherent instability. The debate about measures to reduce that instability may be prolonged, but some proposals have already been put forward. In April 2008 the international Financial Stability Forum attributed the crisis to shortcomings in underwriting, firms' risk management practices, 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. Another international study group has recommended measures to improve the performance of the credit rating agencies , but has also recommended that investors should not treat credit ratings as a substitute for conducting their own risk assessments. Charles Goodhart has proposed that bank capital requirements should be what he terms "contra-cyclical", meaning that they should be raised in times of boom and relaxed in downturns; and also related to the volume of lending , and William White has suggested that monetary policy should be directed to the objective of countering all economic imbalances . He has proposed a system of "augmented inflation targeting", in which the central bank tolerates periods of very low inflation or even deflation if it thinks interest rates need to be high for the sake of the health of the system as a whole

Proposals for reform by Raghuram Rajan, Dani Rodrik, Willem Buiter and others, put forward in advance of the November meeting of the G20 world leaders, have been published as an ebook . The proposals of the G20 leaders are set out in the article on the G20 summit.

(recommendations for the improvement of financial risk-assessment are discussed on the Tutorials subpage, and an account of further proposals for the reform of the financial system is available in the article on the macroprudential financial policy)