The Financial Crisis of 2008: Year in Review 2008

Global financial crisis

Written by: Joel Havemann

In 2008 the world economy faced its most dangerous crisis since the Great
Depression of the 1930s. The contagion, which began in 2007 when sky-high
home prices in the United States finally turned decisively downward, spread
quickly, first to the entire U.S. financial sector and then to financial markets
overseas. The casualties in the United States included a) the entire
investment banking industry, b) the biggest insurance company, c) the two
enterprises chartered by the government to facilitate mortgage lending, d) the
largest mortgage lender, e) the largest savings and loan, and f) two of the largest
commercial banks. The carnage was not limited to the financial sector, however,
as companies that normally rely on credit suffered heavily. The American auto
industry, which pleaded for a federal bailout, found itself at the edge of an abyss.
Still more ominously, banks, trusting no one to pay them back, simply stopped
making the loans that most businesses need to regulate their cash flows and
without which they cannot do business. Share prices plunged throughout the
world—the Dow Jones Industrial Average in the U.S. lost 33.8% of its value in
2008—and by the end of the year, a deep recession had enveloped most of the
globe. In December the National Bureau of Economic Research, the private group
recognized as the official arbiter of such things, determined that a recession had
begun in the United States in December 2007, which made this already the third
longest recession in the U.S. since World War II.

Each in its own way, economies abroad marched to the American drummer. By
the end of the year, Germany, Japan, and China were locked in recession, as were
many smaller countries. Many in Europe paid the price for having dabbled in
American real estate securities. Japan and China largely avoided that pitfall, but
their export-oriented manufacturers suffered as recessions in their major
markets—the U.S. and Europe—cut deep into demand for their products. Less-
developed countries likewise lost markets abroad, and their foreign investment, on
which they had depended for growth capital, withered. With none of the biggest
economies prospering, there was no obvious engine to pull the world out of its
recession, and both government and private economists predicted a rough
recovery.
How did a crisis in the American housing market threaten to drag down the entire
global economy? It began with mortgage dealers who issued mortgages with terms
unfavourable to borrowers, who were often families that did not qualify for ordinary
home loans. Some of these so-called subprime mortgages carried low
“teaser” interest rates in the early years that ballooned to double-digit rates in later
years. Some included prepayment penalties that made it prohibitively expensive
to refinance. These features were easy to miss for first-time home buyers, many
of them unsophisticated in such matters, who were beguiled by the prospect that,
no matter what their income or their ability to make a down payment, they could
own a home.
Mortgage lenders did not merely hold the loans, content to receive a monthly check
from the mortgage holder. Frequently they sold these loans to a bank or to Fannie
Mae or Freddie Mac, two government-chartered institutions created to buy up
mortgages and provide mortgage lenders with more money to lend. Fannie Mae
and Freddie Mac might then sell the mortgages to investment banks that would
bundle them with hundreds or thousands of others into a “mortgage-backed
security” that would provide an income stream comprising the sum of all of the
monthly mortgage payments. Then the security would be sliced into perhaps 1,000
smaller pieces that would be sold to investors, often misidentified as low-risk
investments.
The insurance industry got into the game by trading in “credit default swaps”—in
effect, insurance policies stipulating that, in return for a fee, the insurers would
assume any losses caused by mortgage-holder defaults. What began as
insurance, however, turned quickly into speculation as financial institutions bought
or sold credit default swaps on assets that they did not own. As early as
2003,Warren Buffett, the renowned American investor and CEO of Berkshire
Hathaway, called them “financial weapons of mass destruction.” About $900 billion
in credit was insured by these derivatives in 2001, but the total soared to an
astounding $62 trillion by the beginning of 2008.
As long as housing prices kept rising, everyone profited. Mortgage holders with
inadequate sources of regular income could borrow against their rising home
equity. The agencies that rank securities according to their safety (which are paid
by the issuers of those securities, not by the buyers) generally rated mortgage-
backed securities relatively safe—they were not. When the housing bubble burst,
more and more mortgage holders defaulted on their loans. At the end of
September, about 3% of home loans were in the foreclosure process, an increase
of 76% in just a year. Another 7% of homeowners with a mortgage were at least
one month past due on their payments, up from 5.6% a year earlier. By 2008 the
mild slump in housing prices that had begun in 2006 had become a free fall in
some places. What ensued was a crisis in confidence: a classic case of what
happens in a market economy when the players—from giant companies to
individual investors—do not trust one another or the institutions that they have
built.

The first major institution to go under was Countrywide Financial Corp., the largest
American mortgage lender. Bank of America agreed in January 2008 to terms for
completing its purchase of the California-based Countrywide. With large shares of
Countrywide’s mortgages delinquent, Bank of America was able to buy it for $4
billion on top of the $2 billion stake that it had acquired the previous August—a
fraction of Countrywide’s recent market value.
The next victim, in March, was the Wall Street investment house Bear Stearns,
which had a thick portfolio of mortgage-based securities. As the value of those
securities plummeted, Bear was rescued from bankruptcy by JPMorgan Chase,
which agreed to buy it for a bargain-basement price of $10 per share (about $1.2
billion), and the Federal Reserve (Fed), which agreed to absorb up to $30 billion
of Bear’s declining assets.
If the Fed’s involvement in the bailout of Bear Stearns left any doubt that even a
conservative Republican government—such as that of U.S. Pres. George W.
Bush—could find it necessary to insert itself into private enterprise, the rescue of
Fannie Mae and Freddie Mac in September laid that uncertainty to rest. The two
private mortgage companies, which historically enjoyed a slight edge in the
marketplace by virtue of their congressional charters, held or guaranteed about
half of the country’s mortgages. With the rush of defaults of subprime mortgages,
Fannie and Freddie suffered the same losses as other mortgage companies, only
worse. The U.S. Department of the Treasury, unwilling to abide the turmoil that the
failure of Fannie and Freddie would entail, seized control of them on September 7,
replaced their CEOs, and promised each up to $100 billion in capital if necessary
to balance their books.

The month’s upheavals were not over. With Bear Stearns disposed of, the markets
bid down share prices of Lehman Brothers and Merrill Lynch, two other investment
banks with exposure to mortgage-backed securities. Neither could withstand the
heat. Under pressure from the Treasury, Merrill Lynch, whose “bullish on America”
slogan had made it the popular embodiment of Wall Street, agreed on September
14 to sell itself to Bank of America for $50 billion, half of its market value within the
past year. Lehman Brothers, however, could not find a buyer, and the government
refused a Bear Stearns-style subsidy. Lehman declared bankruptcy the day after
Merrill’s sale.
Next on the markets’ hit list was American International Group (AIG), the country’s
biggest insurer, which faced huge losses on credit default swaps. With AIG unable
to secure credit through normal channels, the Fed provided an $85 billion loan on
September 16. When that amount proved insufficient, the Treasury came through
with $38 billion more. In return, the U.S. government received a 79.9% equity
interest in AIG.
Five days later saw the end for the big independent investment banks. Goldman
Sachs and Morgan Stanley were the only two left standing, and their big investors,
worried that they might be the markets’ next targets, began moving their billions to
safer havens. Rather than proclaim their innocence all the way to bankruptcy court,
the two investment banks chose to transform themselves into ordinary bank
holding companies. That put them under the respected regulatory umbrella of the
Fed and gave them access to the Fed’s various kinds of credit for the institutions
that it regulates.
On September 25, climaxing a frenetic month, federal regulators seized the
country’s largest savings and loan, Seattle-based Washington Mutual (WaMu),
and brokered its sale to JPMorgan Chase for $1.9 billion. JPMorgan also agreed
to absorb at least $31 billion in WaMu’s losses. Finally, in October, the Fed gave
regulatory approval to the purchase of Wachovia Corp., a giant North Carolina-
based bank that was crippled by the subprime-mortgage fiasco, by California-
based Wells Fargo. Other banks also foundered, including some of the largest. In
November the Treasury shored up Citigroup by guaranteeing $250 billion of its
risky assets and pumping $20 billion directly into the bank.
There were competing theories on how so many pillars of finance in the U.S.
crumbled so quickly. One held the issuers of subprime mortgages ultimately
responsible for the debacle. According to this view, when mortgage-backed
securities were flying high, mortgage companies were eager to lend to anyone,
regardless of the borrower’s financial condition. The firms that profited from this—
from small mortgage companies to giant investment banks—deluded themselves
that this could go on forever.Joseph E. Stiglitz of Columbia University, New York
City, the chairman of the Council of Economic Advisers during former president
Bill Clinton’s administration, summed up the situation this way: “There was a party
going on, and no one wanted to be a party pooper.”
Some claimed that deregulation played a major role. In the late 1990s, Congress
demolished the barriers between commercial and investment banking, a change
that encouraged risky investments with borrowed money. Deregulation also ruled
out most federal oversight of “derivatives”—credit default swaps and other financial
instruments that derive their value from underlying securities. Congress also
rejected proposals to curb “predatory loans” to home buyers at unfavorable terms
to the borrowers.
Deregulators scoffed at the notion that more federal regulation would have
alleviated the crisis. Phil Gramm, the former senator who championed much of the
deregulatory legislation, blamed “predatory borrowers” who shopped for a
mortgage when they were in no position to buy a house. Gramm and other
opponents of regulation traced the troubles to the 1977 Community Reinvestment
Act, an antiredlining law that directed Fannie Mae and Freddie Mac to make sure
that the mortgages that they bought included some from poor neighbourhoods.
That, Gramm and his allies argued, was a license for mortgage companies to lend
to unqualified borrowers.
As alarming as the blizzard of buyouts, bailouts, and collapses might have been,
it was not the most ominous consequence of the financial crisis. That occurred in
the credit markets, where hundreds of billions of dollars a day are lent for periods
as short as overnight by those who have the capital to those who need it. The
banks that did much of the lending concluded from the chaos taking place in
September that no borrower could be trusted. As a result, lending all but froze.
Without loans, businesses could not grow. Without loans, some businesses could
not even pay for day-to-day operations.
Then came a development that underscored the enormity of the crisis.
The Reserve Primary Fund, one of the U.S.’s major money-market funds,
announced on September 16 that it would “break the buck.” Money-market funds
constitute an important link in the financial chain because they use their deposits
to make many of the short-term loans that large corporations need. Although
money-market funds carry no federal deposit insurance, they are widely regarded
as being just as safe as bank deposits, and they attract both large and small
investors because they earn rates of return superior to those offered by the safest
of all investments, U.S. Treasury securities. So it came as a jolt when Reserve
Primary, which had gotten into trouble with its loans to Lehman Brothers,
proclaimed that it would be unable to pay its investors any more than 97 cents on
the dollar. The announcement triggered a stampede out of money-market funds,
with small investors joining big ones. Demand for Treasury securities was so great
that the interest rate on a three-month Treasury bill was bid down practically to
zero. In a September 18 meeting with members of Congress, Fed Chairman Ben
S. Bernanke was heard to remark that if someone did not do something fast, by
the next week there might not be an economy to rescue.
If government policy makers had taken any lesson from the Great Depression, it
was that tight money, high taxes, and government spending restraint could
aggravate the crisis. The Treasury and the Fed seemed to compete for the honour
of biggest economic booster. The Fed’s usual tool—reducing short-term interest
rates—did not unlock the credit markets. By year’s end its target for the federal
funds rate, which banks charge one another for overnight loans, was about as low
as it could get: a range of 0–0.25%. So the Fed dusted off other ways of injecting
money into the economy, through loans, loan guarantees, and purchases of
government securities. By December the Fed had pumped more than $1 trillion
into the economy and signaled its intention to do much more.
Treasury Secretary Henry Paulson asked Congress to establish a $700 billion fund
to keep the economy from seizing up permanently. Paulson initially intended to
use the new authority to buy mortgage-based securities from the institutions that
held them, thus freeing their balance sheets of toxic investments. This approach
drew a torrent of criticism: How could anyone determine what the securities were
worth (if anything)? Why bail out the large institutions but not the homeowners who
were duped into taking out punitive mortgages? How would the plan encourage
banks to resume lending? The House of Representatives voted his plan down
once before accepting a slightly revised version.
After the plan’s enactment, Paulson, acknowledging that his approach would not
encourage sufficient new bank lending, did a U-turn. The Treasury would instead
invest most of the newly authorized bailout fund directly into the banks that held
the toxic securities (thus giving the government an ownership stake in private
banks). This, Paulson and others argued, would enable the banks to resume
lending. By the end of 2008, the government owned stock in 206 banks. The
Treasury’s new stance appeared to open access to the bailout money to anyone
suffering from the frozen credit markets. This was the basis for the auto
manufacturers’ plea for a piece of the pie.
Still, all that money did little, at least at first, to stimulate private bank lending.
Everyone with money to lend turned to the safest haven of all—Treasury securities.
So popular were short-term Treasuries that investors in December bought $30
billion worth of four-week Treasury bills that paid no interest at all, and, very briefly,
the market interest rate on three-month Treasuries was negative.

The Bush administration did little with tax and spending policy to combat the
recession. Sen. Barack Obama, who was elected in November to succeed
President Bush as of Jan. 20, 2009, prepared a package of about $1 trillion in tax
cuts and spending programs to stimulate economic activity.

Although the financial crisis wore a distinct “Made in the U.S.A.” label, it did not
stop at the water’s edge. The U.K. government provided $88 billion to buy banks
completely or partially and promised to guarantee $438 billion in bank loans. The
government began buying up to $64 billion worth of shares in the Royal Bank of
Scotland and Lloyds TSB Group after brokering Lloyds’ purchase of the troubled
HBOS bank group. The U.K. government’s hefty stake in the country’s banking
system raised the specter of an active role in the boardrooms. Barclays, telling the
government “thanks but no thanks,” instead accepted $11.7 billion from wealthy
investors in Qatar and Abu Dhabi, U.A.E.
Variations played out all through Europe. The governments of the three Benelux
countries—Belgium, The Netherlands, and Luxembourg—initially bought a 49%
share in Fortis NV within their respective countries for $16.6 billion, though
Belgium later sold most of its shares and The Netherlands nationalized the bank’s
Dutch holdings. Germany’s federal government rescued a series of state-owned
banks and approved a $10.9 billion recapitalization of Commerzbank. In the
banking centre of Switzerland, the government took a 9% ownership stake in
UBS. Credit Suisse declined an offer of government aid and, going the way of
Barclays, raised funds instead from the government of Qatar and private investors.
The most spectacular troubles broke out in the far corners of Europe. In Greece
street riots in December reflected, among other things, anger with economic
stagnation. Iceland found itself essentially bankrupt, with Hungary and Latvia
moving in the same direction. Iceland’s three largest banks, privatized in the early
1990s, had grown too large for their own good, with assets worth 10 times the
entire country’s annual economic output. When the global crisis reached Iceland
in October, the three banks collapsed under their own weight. The national
government managed to take over their domestic branches, but it could not afford
their foreign ones.
As in the U.S., the financial crisis spilled into Europe’s overall economy. Germany’s
economic output, the largest in Europe, contracted at annual rates of 0.4% in the
second quarter and 0.5% in the third quarter. Output in the 15 euro zone countries
shrank by 0.2% in each of the second and third quarters, marking the first
recession since the euro’s debut in 1999.
In an atmosphere that bordered on panic, governments throughout Europe
adopted policies aimed at keeping the recession short and shallow. On monetary
policy, the central banks of Europe coordinated their interest-rate reductions. On
December 4 the European Central Bank, the steward of monetary policy for the
euro zone, engineered simultaneous rate cuts with the Bank of England and
Sweden’s Riksbank. A week later the Swiss National Bank cut its benchmark rate
to a range of 0–1%. On fiscal policy, European governments for the most part
scrambled to approve public-spending programs designed to pump money into the
economy. The EU drew up a list of $258 billion worth of public spending that it
hoped would be adopted by its 27 member countries. The French government said
that it would spend $33 billion over the next two years. Most other countries
followed suit, though Germany hung back as Chancellor Angela Merkel argued for
fiscal restraint.
Asia’s major economies were swept up by the financial crisis, even though most
of them suffered only indirect blows. Japan’s and China’s export-oriented
industries suffered from consumer retrenchment in the U.S. and Europe.
Compounding the damage, exporters could not find loans in the West to finance
their sales. Japan hit the skids in the second quarter of 2008 with a 3.7%
contraction at an annual rate, followed by 0.5% in the third quarter. Its all-important
exports plunged 27% in November from 12 months earlier. The government
announced a $250 billion package of fiscal stimulus in December on top of $50
billion earlier in the year. Unlike so many others, China’s economy continued to
grow but not at the double-digit rates of recent years. Exports were actually lower
in November than in the same month a year earlier, quite a change from October’s
19% increase. The government prepared a two-year $586 billion economic
stimulus plan, and the central bank repeatedly cut interest rates.
The U.S., Europe, and Asia had this in common—car makers were at the head of
the line of industries pleading for help. The U.S. Senate turned down $14 billion in
emergency loans; the car companies got into this mess, senators argued, and it
was up to them to get out of it. President Bush, rather than risk the demise
of General Motors (GM) and Chrysler, tapped the $700 billion financial sector
bailout fund to provide $17 billion in loans—enough to keep the two companies
afloat until safely after the Obama administration took over in early 2009. In
addition, the Treasury invested in a $5 billion equity position with GMAC, GM’s
financing company, and loaned it another $1 billion. In Europe, Audi, BMW,
Daimler, GM, Peugeot, and Renault announced production cuts, but European
government officials were reluctant to aid a particular industry for fear that others
would soon be on their doorstep. Even in China, car sales growth turned negative.
As elsewhere, the industry held out its tin cup, but the government left it empty.
The pressures of the financial crisis seemed to be forging more new alliances.
Officials from Washington to Beijing coordinated interest rate cuts and fiscal
stimulus packages. Top officials from China, Japan, and South Korea—longtime
adversaries—met in China and promised a cooperative response to the crisis. Top-
level representatives of the Group of 20 (G-20)—a combination of the world’s
richest countries and some of its fastest-growing—met in Washington in November
to lay the groundwork for global collaboration. The G-20’s deliberations were
necessarily tentative in light of the U.S. presidential transition in progress.
By year’s end, all of the world’s major economies were in recession or struggling
to stay out of one. In the final four months of 2008, the U.S. lost nearly two million
jobs. The unemployment rate shot up to 7.2% in December from its recent low of
4.4% in March 2007, and it was almost certain to continue rising into 2009.
Economic output shrank by 0.5% in the third quarter, and announced layoffs and
severe cutbacks in consumer spending suggested that the fourth quarter saw a
sharper contraction. It was doubtful that the worldwide economic picture would
grow brighter anytime soon. Forecast after forecast showed lethargic global
economic growth for at least 2009. “Virtually no country, developing or industrial,
has escaped the impact of the widening crisis,” the World Bank reported in a typical
year-end assessment. It forecast an increase in global economic output of just
0.9% in 2009, the most tepid growth rate since records became available in 1970.
Measured by its impact on global economic output, the recession that had engulfed
the world by the end of 2008 figured to be sharper than any other since the Great
Depression. The two periods of hard times had little else in common, however; the
Depression started in the manufacturing sector, while the current crisis had its
origins in the financial sector. Perhaps a more apt comparison could be found in
the Panic of 1873. Then, as in 2008, a real estate boom (in Paris, Berlin, and
Vienna, rather than in the U.S.) went sour, losing a cascade of misfortune. The
ensuing collapse lasted four years.