Financial crisis of 2007–2009

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This article is about the series of financial market events, starting in July 2007, which
suggested a weakening in the world economies. For details on the stock market crashes
and bank bailouts of late 2008, see Global financial crisis of 2008–2009. For economic
issues beyond the financial markets, see Late 2000s recession. For discussion of a major
aspect of response to the crisis, see The Keynesian Resurgence of 2008 / 2009

The financial crisis of 2007–2009, often referred to as "the credit crunch" or "credit crisis",
began in July 2007[1] when a loss of confidence by investors in the value of securitized mortgages
in the United States resulted in a liquidity crisis that prompted a substantial injection of capital
into financial markets by the United States Federal Reserve, Bank of England and the European
Central Bank.[2][3] The TED spread, an indicator of perceived credit risk in the general economy,
spiked up in July 2007, remained volatile for a year, then spiked even higher in September 2008,
[4]
reaching a record 4.65% on October 10, 2008. In September 2008, the crisis deepened, as
stock markets world-wide crashed and entered a period of high volatility, and a considerable
number of banks, mortgage lenders and insurance companies failed in the following weeks.

Share in GDP of US financial sector since 1860.[5]

Although America's housing collapse is often cited as having caused the crisis, the financial
system was vulnerable because of intricate and highly-leveraged financial contracts and
operations, a U.S. monetary policy making the cost of credit negligible therefore encouraging
such high levels of leverage, and generally a "hypertrophy of the financial sector"
(financialization). [6]

Contents
[hide]
 • 1 Scope
• 2 Root of the financial crisis
• 3 Origins and growth of the housing bubble
• 4 First effects of the bubble's collapse
o 4.1 Risks and regulations
• 5 Developing global financial crisis
• 6 Economic aspects and projections
o 6.1 Global aspects
 6.1.1 US aspects
o 6.2 Official prospects
• 7 Timeline of events
o 7.1 Background
o 7.2 Events of 2007
o 7.3 Events of 2008
o 7.4 Events of 2009
• 8 Suggested consequences for the theory
• 9 See also
• 10 References

• 11 External links

[edit] Scope
The crises in real estate, banking and credit in the United States had a global reach, affecting a
wide range of financial and economic activities and institutions, including the:

• Overall tightening of credit with financial institutions making both corporate and
consumer credit harder to get;
• Financial markets (stock exchanges and derivative markets) that experienced steep
declines;
• Liquidity problems in equity funds and hedge funds;
• Devaluation of the assets underpinning Insurance contracts and pension funds leading to
concerns about the ability of these instruments to meet future obligations:
• Increased public debt public finance due to the provision of public funds to the finance
and other affected industries, and the
• Devaluation of some currencies (Icelandic crown, some Eastern Europe and Latin
America currencies) and increased currency volatility,

The first symptoms of what is now called the late 2000s recession ensued also in various
countries and various industries. The financial crisis, albeit not the only cause among other
economic imbalances, was a factor by making borrowing and equity raising harder.

[edit] Root of the financial crisis

The root cause of the financial crisis was the collapse of the $8 trillion bubble in the US housing
market. In August 2002, Dean Baker was the first economist to say that there was a housing
bubble in the US, basing his analysis on US-government house-price-data from 1953 to 1995. [7]
In his analysis, Baker wrote that from 1953 to 1995 house prices had simply tracked inflation,
but that when house prices from 1995 onwards were adjusted for inflation they showed a marked
increase over and above inflation-based increases. Baker correctly drew the conclusion of the
existence of a bubble in the US housing market and, along with a small handful of other
economists, predicted an ensuing crisis. It later proved impossible to convince responsible parties
such as the Board of Governors of the Federal Reserve of the need for action, however.[8][9]
Baker's argument was confirmed with the construction of a data series from 1895 to 1995 by the
influential Yale economist Robert Shiller which showed that real house prices had been
essentially unchanged over that 100 years.[10] Long before the collapse took place, at the end of
September 2002, Baker also correctly predicted that, "The collapse of the housing bubble will
also jeopardize the survival of Fannie Mae and Freddie Mac and numerous other financial
institutions."[11] A common claim during the first weeks of the financial crisis was that the
problem was simply caused by reckless, sub-prime lending. As Baker has pointed out repeatedly,
however, the sub-prime mortgages were only part of a far more extensive problem affecting the
entire $20 trillion US housing market: the sub-prime sector was simply the first place that the
collapse of the bubble affecting the housing market showed up.

[edit] Origins and growth of the housing bubble

The housing bubble[12] grew up alongside the stock bubble of the mid-1990s. People who had
increased their wealth substantially with the extraordinary run-up of stock prices were spending
based on this increased wealth. This led to the consumption boom of the late 1990s, with the
savings rate out of disposable income falling from five percent in the mid-90s to two percent by
2000. The stock-wealth induced consumption boom led people to buy bigger and/or better
homes, since they sought to spend some of their new stock wealth on housing.

The next phase of the housing bubble was the supply-side effect of the dramatic increase in
house prices, as housing starts rose substantially from the mid-1990s onwards. Baker notes that if
the course of the bubble in the United States had followed the same pattern as in Japan, the
housing bubble would have collapsed along with the collapse of the stock bubble between 2000-
2002. Instead, the collapse of the stock bubble helped to feed the US housing bubble. After
collectively losing faith in the stock market, millions of people turned to investments in housing
as a safe alternative. In addition, the economy was very slow in recovering from the 2001
recession, the weakness of the recovery leading the Federal Reserve Board to continue to cut
interest rates - one of numerous occasions where the Fed cut rates in response to a crisis, a
pattern of behaviour that had, by that time, become known as a Greenspan put. Fixed-rate
mortgages and other interest rates hit 50-year lows. To further fuel the housing market, Federal
Reserve Board Chairman Alan Greenspan suggested that homebuyers were wasting money by
buying fixed rate mortgages instead of adjustable rate mortgages (ARMs). This was peculiar
advice at a time when fixed rate mortgages were near 50-year lows, but even at the low rates of
2003 homebuyers could still afford larger mortgages with the adjustable rates available at the
time.
The bubble began to burst in 2007, as the building boom led to so much over-supply that prices
could no longer be supported. Prices nationwide began to head downward, with this process
accelerating through the fall of 2007 and into 2008. As prices decline, more homeowners face
foreclosure. This increase in foreclosures is in part voluntary and in part involuntary. It can be
involuntary, since there are cases where people who would like to keep their homes, who would
borrow against equity if they could not meet their monthly mortgage payments. When falling
house prices destroy equity, they eliminate this option. The voluntary foreclosures take place
when people realize that they owe more than the value of their home, and decide that paying off
their mortgage is in effect a bad deal. In cases where a home is valued far lower than the amount
of the outstanding mortgage, homeowners may be able to effectively pocket hundreds of
thousands of dollars (or pounds) by simply walking away from their mortgage.

[edit] First effects of the bubble's collapse

2007 bank run on Northern Rock, a UK bank

One of the first victims was Northern Rock, a medium-sized British bank.[13] The highly
leveraged nature of its business led the bank to request security from the Bank of England. This
in turn led to investor panic and a bank run in mid-September 2007. Calls by Liberal Democrat
Shadow Chancellor Vince Cable to nationalise the institution were initially ignored; in February
2008, however, the British government (having failed to find a private sector buyer) relented,
and the bank was taken into public hands. Northern Rock's problems proved to be an early
indication of the troubles that would soon befall other banks and financial institutions.

Initially the companies affected were those directly involved in home construction and mortgage
lending such as Northern Rock and Countrywide Financial. Financial institutions which had
engaged in the securitization of mortgages such as Bear Stearns then fell prey. Later on, Bear
Stearns was acquired by JP Morgan Chase through deliberate assistance from the US
government. Its stock price plunged to $3 in reaction to the buyout offer of $2 by JP Morgan
Chase, well below its 52 week high of $134. Subsequently, the acquisition price was raised to
$10 by JP Morgan. On July 11, 2008, the largest mortgage lender in the US, IndyMac Bank,
collapsed, and federal regulators seized its assets after the mortgage lender succumbed to the
pressures of tighter credit, tumbling home prices and rising foreclosures. That day the financial
markets plunged as investors tried to gauge whether the government would attempt to save
mortgage lenders Fannie Mae and Freddie Mac, which it did by placing the two companies into
federal conservatorship on September 7, 2008 after the crisis further accelerated in late summer.

See also: Federal takeover of Fannie Mae and Freddie Mac

The media have repeatedly argued that the crisis then began to affect the general availability of
credit to non-housing related businesses and to larger financial institutions not directly connected
with mortgage lending. While this is true, the reasons given in media reporting are usually
inaccurate. Dean Baker has repeatedly explained the actual, underlying problem:

"Yes, consumers and businesses can't get credit as easily as they could a year ago. There is a
really good reason for tighter credit. Tens of millions of homeowners who had substantial equity
in their homes two years ago have little or nothing today. Businesses are facing the worst
downturn since the Great Depression. This matters for credit decisions. A homeowner with
equity in her home is very unlikely to default on a car loan or credit card debt. They will draw on
this equity rather than lose their car and/or have a default placed on their credit record. On the
other hand, a homeowner who has no equity is a serious default risk. In the case of businesses,
their creditworthiness depends on their future profits. Profit prospects look much worse in
November 2008 than they did in November 2007 (of course, to clear-eyed analysts, they didn't
look too good a year ago either). While many banks are obviously at the brink, consumers and
businesses would be facing a much harder time getting credit right now even if the financial
system were rock solid. The problem with the economy is the loss of close to $6 trillion in
housing wealth and an even larger amount of stock wealth.

The New York City headquarters of Lehman Brothers.

Economists, economic policy makers and economic reporters virtually all missed the housing
bubble on the way up. If they still can't notice its impact as the collapse of the bubble throws into
the worst recession in the post-war era, then they are in the wrong profession."[14]

At the heart of the portfolios of many of these institutions were investments whose assets had
been derived from bundled home mortgages. Exposure to these mortgage-backed securities, or to
the credit derivatives used to insure them against failure, threatened an increasing number of
firms such as Lehman Brothers, AIG, Merrill Lynch, and HBOS.[15][16][16][17]

Other firms that came under pressure included Washington Mutual, the largest savings and loan
association in the United States, and the remaining large investment firms, Morgan Stanley and
Goldman Sachs.[18][19]

[edit] Risks and regulations

As financial assets became more and more complex, and harder and harder to value, investors
were reassured by the fact that both the international bond rating agencies and bank regulators,
who came to rely on them, accepted as valid some complex mathematical models which
theoretically "showed" the risks were much smaller than they actually proved to be in practice
[20]
. George Soros commented that "The super-boom got out of hand when the new products
became so complicated that the authorities could no longer calculate the risks and started relying
on the risk management methods of the banks themselves. Similarly, the rating agencies relied
on the information provided by the originators of synthetic products. It was a shocking
abdication of responsibility." [21]

[edit] Developing global financial crisis

Main article: Global financial crisis of 2008

Dow Jones Industrial Average Jan 2006 - Nov 2008

Beginning with bankruptcy of Lehman Brothers on September 14, 2008, the financial crisis
entered an acute phase marked by failures of prominent American and European banks and
efforts by the American and European governments to rescue distressed financial institutions, in
the United States by passage of the Emergency Economic Stabilization Act of 2008 and in
European countries by infusion of capital into major banks. Afterwards, Iceland almost claimed
to go bankrupt as the countries three largest banks, and in effect financial system, collapsed.[22]
Many financial institutions in Europe also faced the liquidity problem that they needed to raise
their capital adequacy ratio. As the crisis developed, stock markets fell worldwide, and global
financial regulators attempted to coordinate efforts to contain the crisis. The US government
composed a $700 billion plan to purchase unperforming collaterals and assets. However, the plan
failed to pass because some members of the US Congress rejected the idea of using taxpayers'
money to bail out Wall Street investment bankers. After the stock market plunged, Congress
amended the $700 billion bail out plan and passed the legislation. The market sentiment
continued to deteriorate, however, and the global financial system almost collapsed. While the
market turned extremely pessimistic, the British government launched a 500 billion pound bail
out plan aimed at injecting capital into the financial system. The British government nationalized
most of the financial institutions in trouble. Many European governments followed suit, as well
as the US government. Stock markets appeared to have stabilized as October ended. In addition,
the falling prices due to reduced demand for oil, coupled with projections of a global recession,
brought the 2000s energy crisis to temporary resolution.[23][24] In the Eastern European economies
of Poland, Hungary, Romania, and Ukraine the economic crisis was characterized by difficulties
with loans made in hard currencies such as the Swiss franc. As local currencies in those countries
lost value, making payment on such loans became progressively more difficult.[25]

As the financial panic developed during September and October 2008, there was a "flight-to-
quality" as investors sought safety in U.S. Treasury bonds, gold, and currencies such as the US
dollar (still widely perceived as the world’s reserve currency) and the Yen (mainly through
unwinding of carry trades). This currency crisis threatened to disrupt international trade and
produced strong pressure on all world currencies. The International Monetary Fund had limited
resources relative to the needs of the many nations with currency under pressure or near collapse.
[26]

A further shift towards assets that are perceived as tangible, sustainable, like gold [27] or land [28]
[29]
(as opposed to “paper assets”) is being anticipated unless confidence is generally restored.

[edit] Economic aspects and projections

Main article: Late 2000s recession

[edit] Global aspects

A number of commentators have suggested that if the liquidity crisis continues, there could be an
extended recession or worse.[30] The continuing development of the crisis prompted fears of a
global economic collapse.[31] The financial crisis is likely to yield the biggest banking shakeout
since the savings-and-loan meltdown.[32] Investment bank UBS stated on October 6 that 2008
would see a clear global recession, with recovery unlikely for at least two years.[33] Three days
later UBS economists announced that the "beginning of the end" of the crisis had begun, with the
world starting to make the necessary actions to fix the crisis: capital injection by governments;
injection made systemically; interest rate cuts to help borrowers. The United Kingdom had
started systemic injection, and the world's central banks were now cutting interest rates. UBS
emphasized the United States needed to implement systemic injection. UBS further emphasized
that this fixes only the financial crisis, but that in economic terms "the worst is still to come".[34]
UBS quantified their expected recession durations on October 16: the Eurozone's would last two
quarters, the United States' would last three quarters, and the United Kingdom's would last four
quarters.[35]
At the end of October UBS revised its outlook downwards: the forthcoming recession would be
the worst since the Reagan recession of 1981 and 1982 with negative 2009 growth for the US,
Eurozone, UK and Canada; very limited recovery in 2010; but not as bad as the Great
Depression.[36]

It was widely argued that an international crisis required an international solution. In The
Keynesian Resurgence of 2008 / 2009, the economist John Maynard Keynes was widely cited as
providing the best insight into the kind of policy response required, including the need for
international coordination of economic policy responses.

[edit] US aspects

Real gross domestic product — the output of goods and services produced by labor and property
located in the United States — decreased at an annual rate of 0.3 percent in the third quarter of
2008, (that is, from the second quarter to the third quarter), according to advance estimates
released by the Bureau of Economic Analysis. In the second quarter, real GDP increased 2.8
percent. Real disposable personal income decreased 8.7 percent.[37]

Nouriel Roubini, professor of economics at New York University and chairman of RGE
Monitor, predicted a recession of up to two years, unemployment of up to nine percent, and
another 15 percent drop in home prices.[38] Moody's Investors Service continued in October 2008
to project increased foreclosures for residential mortgages originating in 2006 and 2007. These
increases may result in downgrades of the credit rating of bond insurers Ambac, MBIA,
Financial Guaranty Insurance Company, and CIFG.[39] The bond insurers, meantime, together
with their insurance regulators, are negotiating with the Treasury regarding possible capital
infusions or other relief under the $700 billion bailout plan. In addition to mortgage backed
bonds, the bond insurers back hundreds of billions of dollars of municipal and other bonds. Thus,
a ripple effect could spread beyond the mortgage sector should there be a major downgrade in
credit ratings or failure of the companies. [40]

[edit] Official prospects

On November 3, 2008, the EU-commission at Brussels predicted for 2009 an extremely weak
growth of the BIP, by 0.1 percent, for the countries of the Euro zone (France, Germany, Italy,
etc.) and even negative number for the UK (-1.0 percent), Ireland and Spain. On November 6,
the IMF at Washington, D.C., launched numbers predicting a worldwide recession by -0.3
percent for 2009, averaged over the developed economies. On the same day, the Bank of
England and the Central Bank for the Euro zone, respectively, reduced their interest rates from
4.5 percent down to three percent, and from 3.75 percent down to 3.25 percent. Economically,
mainly the car industry seems to be involved. As a consequence, starting from November 2008,
several countries launched large "help packages" for their economies.

[edit] Timeline of events

Main article: Subprime crisis impact timeline
[edit] Background

• Financialization (general evolutions in the area of finance which preceded the crisis)
• Subprime mortgage crisis
• Systemic risk

[edit] Events of 2007

• August, 2007: Liquidity crisis emerges[3][41][42]

• September, 2007: Northern Rock seeks and receives a liquidity support facility from the
Bank of England[43]
• October, 2007: Record high US stock market October 9, 2007 Dow Jones Industrial
Average (DJIA) 14,164[44]

[edit] Events of 2008

• January, 2008: Stock Market Volatility

• February, 2008: Nationalisation of Northern Rock[45]
• March, 2008: Collapse of Bear Stearns
• March, 2008: Federal takeover of Fannie Mae and Freddie Mac
• September, 2008: Global Financial Crisis
• September, 2008: Bankruptcy of Lehman Brothers
• September, 2008: partial nationalization of Fortis holding
• October, 2008: Large losses in financial markets world wide throughout September and
October
• October, 2008: Passage of EESA of 2008
• October, 2008: Iceland's major banks nationalized
• November, 2008: China creates a stimulus plan
• November, 2008: Dow Jones Industrial Average (DJIA) touches recent low point of
7,507 points[citation needed]
• December, 2008: The Australian Government injects 'economic stimulus package' to
avoid the country going into recession, December, 2008
• December, 2008: Madoff Ponzi scheme scandal erupts

[edit] Events of 2009

• January 2009: U.S. President Barack Obama proposes federal spending bill approaching
$1 trillion in value in an attempt to remedy financial crisis [46]
• January 2009: Lawmakers propose massive bailout of failing U.S. banks [47]
• January 2009: the U.S. House of Representatives passes the aforementioned spending
bill.
• January 2009: Government of Iceland collapses. [48]
• February 2009: Canada's Parliament passes an early budget with a $40 billion stimulus
package.
 • February 2009: JPMorgan Chase and Citigroup formally announce a temporary
moratorium on residential foreclosures. The moratoriums will remain in effect until
March 6 for JPMorgan and March 12 for Citigroup.[49]
• February, 2009: U.S. President Barack Obama signs the $787 billion American Recovery
and Reinvestment Act of 2009 into law. [50]
• February 2009: The Australian Government seeks to enact another "economic stimulus
package".
• February 2009: 2009 Eastern European financial crisis arises.
• February 2009: The Bank of Antigua is taken over by the Eastern Caribbean Central
Bank after Sir Allen Stanford is accused by US financial authorities of involvement in an
$8bn (£5.6bn) investment fraud. Peru, Venezuela, and Ecuador, had earlier suspended
operations at banks owned by the group. [51]
• February, 23rd 2009: The Dow Jones Industrial Average and the S&P 500 indexes
stumbled to lows not seen since 1997.
• February 27th 2009: The S&P index closes at a level not seen since December 1996, and
also closes the two month period beginning January 1st with the worst two month
opening to a year in its history with a loss in value of 18.62%

[edit] Suggested consequences for the theory

In an online-article [52] in the influential German newspaper Frankfurter Allgemeine Zeitung,
published on February 18, 2009, the author, Joachim Starbatty, blames his colleagues from
economic theory for concentrating too much on pre-critical states and the present situation,
instead of generating practical indicators for imminent dangerous events. In fact, in physical
(thermal) equilibrium it is, according to a famous statement, "impossible to generate energy or
useful work out of itself (impossibility of a 'perpetuum mobile of the 1st or 2nd kind')". [53]

So, by analogy, a "bubble", e.g. the mortgage crisis and it's consequences, is a genuine non-
equilibrium event, and has a finite lifetime which needs to be calculated or estimated, as is also
true for the recovery-time from any crisis.