The Financial Crisis of 2008: Year

In Review 2008
GLOBAL FINANCIAL CRISIS
WRITTEN BY:
Joel Havemann
See Article History
Originally published in the Britannica Book of the Year. Presented as archival content. Learn more.

BRITANNICA STORIES

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 worldthe Dow Jones Industrial Average in the U.S.
lost 33.8% of its value in 2008and 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 marketsthe U.S. and Europecut 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.

Origins
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 safethey 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 playersfrom giant companies to individual investorsdo
not trust one another or the institutions that they have built.

The Crisis Unfolds

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 Countrywides 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 Augusta fraction of Countrywides 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 Bears declining assets.
If the Feds involvement in the bailout of Bear Stearns left any doubt that even
a conservative Republican governmentsuch as that of U.S. Pres. George
W. Bushcould 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 countrys 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 months 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 Merrills sale.

A demonstrator holds up an ominous placard outside the headquarters of Lehman Brothers in New York
Mary Altaffer/AP

Next on the markets hit list was American International Group (AIG), the countrys
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 Feds various kinds of credit for the institutions that it
regulates.
On September 25, climaxing a frenetic month, federal regulators seized the countrys
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 WaMus 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
borrowers financial condition. The firms that profited from thisfrom small
mortgage companies to giant investment banksdeluded 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 Clintons
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 derivativescredit 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 unfavourable 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 Feds usual toolreducing short-term interest ratesdid not
unlock the credit markets. By years 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 00.25%. 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 plans 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 Treasurys 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 allTreasury 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.

International Repercussions
Although the financial crisis wore a distinct Made in the U.S.A. label, it did not stop
at the waters 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. governments hefty stake in the countrys banking
system raised the spectre 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 countriesBelgium, The Netherlands, and Luxembourginitially
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 banks Dutch holdings. Germanys 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. Icelands three largest banks,
privatized in the early 1990s, had grown too large for their own good, with
assets worth 10 times the entire countrys 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 Europes overall economy.
Germanys 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 euros 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 Swedens Riksbank. A week later the Swiss National
Bank cut its benchmark rate to a range of 01%. 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.
Asias major economies were swept up by the financial crisis, even though
most of them suffered only indirect blows. Japans and Chinas 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, Chinas
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 Octobers 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 commoncar 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 loansenough 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, GMs 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 adversariesmet in China and promised a cooperative response to
the crisis. Top-level representatives of the Group of 20 (G-20)a combination
of the worlds richest countries and some of its fastest-growingmet in
Washington in November to lay the groundwork for global collaboration. The
G-20s deliberations were necessarily tentative in light of the U.S. presidential
transition in progress.
By years end, all of the worlds 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,
loosing a cascade of misfortune. The ensuing collapse lasted four years.