What Caused the 2008 Financial Crash? | History Hit

What Caused the 2008 Financial Crash?

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A 2008 newspaper headline during the financial crisis.
Image Credit: Norman Chan / Shutterstock

The 2008 financial crash was one of the most seismic events in modern history for global financial markets, sparking massive bailouts of banks by governments in order to keep from a total economic collapse, and a major recession felt the world over.

However, the crash had been years in the making: it wasn’t a question of if, for many economists, but when. The collapse of the major American investment bank, Lehman Brothers, in September 2008, was the first of several banks filing for bankruptcy, and the start of several years of economic recession which would hit millions of people.

But what exactly was it that had been brewing under the surface for decades? Why did one of America’s oldest and outwardly most successful investment banks go bankrupt? And just how true is the maxim ‘too big to fail’?

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A fluctuating market

Ups and downs in the financial world are nothing new: from the 1929 Wall Street Crash to Black Monday in 1987, periods of economic boom followed by recessions or crashes are nothing new.

Beginning with the Reagan and Thatcher years of the 1980s, market liberalisation and enthusiasm for the free market economy began to stimulate growth. This was followed up by major deregulation of the financial sector across Europe and America, including the repeal of Glass-Steagall legislation in the 1990s. Combined with new legislation introduced for the encouragement of financing in the property market, there were several years of major financial boom.

Banks began to relax credit lending standards, which in turn led to them agreeing to riskier loans, including mortgages. This led to a housing bubble, particularly in America, as people began to take advantage of the opportunity to take out second mortgages or invest in more property. Large-scale borrowing became much more frequent and fewer checks were made.

Two major government-sponsored enterprises (GSEs) known as Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), were big players in the secondary mortgage market in America. They existed to provide mortgage-backed securities, and effectively had a monopoly on the market.

Fraud and predatory lending

Whilst many benefitted, at least in the short term, from easier access to loans, there were also plenty willing to take advantage of the situation.

Lenders stopped asking for documentation for loans, leading to a collapse in mortgage underwriting standards. Predatory lenders also became increasingly problematic: they used false advertising and deception to encourage people to take out complicated, high-risk loans. Mortgage fraud also became an increasing issue.

Many of these issues were compounded by an unquestioning blind eye being turned by the newly deregulated financial institutions. Banks were not questioning loans or unconventional business practices as long as business was booming.

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The beginning of the crash

Made famous by the 2015 film The Big Short, those who looked closely at the market saw its unsustainability: fund manager Michael Burry placed doubt on subprime mortgages as early as 2005. His doubts were met with derision and laughter. As far as many economists were concerned, free-market capitalism was the answer, and the collapse of communism in Eastern Europe, and China’s recent adoption of more capitalist policies, only served to back them up.

In the spring of 2007, subprime mortgages began to come under greater scrutiny from banks and real estate companies: shortly afterwards, several of America’s real estate and mortgage firms filed for bankruptcy, and investment banks like Bear Stearns bailed out hedge funds which had been involved in, or potentially could be put at risk by, subprime mortgages and over-generous loans which people could not, nor would not, be able to ever pay back.

Banks began to stop co-operating with each other, and in September 2007, Northern Rock, a big British bank, required aid from the Bank of England. As it became increasingly clear something was beginning to go horribly, people began to lose faith in banks. This sparked a run on the banks, and in turn, major bailouts in order to keep banks afloat and to stop the worst-case scenario from happening.

Fannie Mae and Freddie Mac, who between them owned and guaranteed around half of America’s $12 trillion mortgage market, looked to be on the verge of collapse in the summer of 2008. They were placed under conservatorship and huge amounts of funds were poured into them in order to prevent the two GSEs from going bankrupt.

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Spilling over into Europe

In a globalised world, America’s financial problems quickly impacted the rest of the world, including Europe. The relatively newly-created eurozone faced its first major challenge. Countries within the eurozone could borrow on similar terms, despite having extremely different financial situations, because the eurozone was effectively providing a level of financial security, and the possibility of a bailout.

When the crisis did hit Europe, countries like Greece, which had large amounts of debt and found themselves hit hard, were bailed out but on strict conditions: they had to pursue an economic policy of austerity.

Iceland, another country which had benefited from the boom as it provided easy access for foreign creditors, also suffered as several of its major banks were liquidated. Their debt was so big that they could not be bailed out sufficiently by the Central Bank of Iceland, and millions of people lost money deposited with them as a result. In early 2009, the Icelandic government collapsed after weeks of protests over its handling of the crisis.

Protests against the Icelandic government’s handling of the economic crisis in November 2008.

Image Credit: Haukurth / CC

Too big to fail?

The idea of banks being ‘too big to fail’ first sprung up in the 1980s: it means that some banks and financial institutions were so big and interconnected, that should they fail it may well precipitate a major economic collapse. As a result, they must be propped up or bailed out by governments at virtually all costs.

In 2008-2009, governments around the world began pouring money into bank bailouts on an almost unprecedented scale. Whilst they saved several banks as a result, many began wondering whether these bailouts were worth the high cost that ordinary people were forced to pay as a result.

Economists increasingly began to scrutinise the idea of any bank being ‘too big to fail’: whilst some still support the idea, arguing regulation is the real issue, many others consider it a dangerous place to be in, arguing anything that is ‘too big to fail’ is simply actually too big and should be broken down into smaller banks.

In 2014, the International Monetary Fund declared that the issue of the ‘too big to fail’ doctrine remained unresolved. It looks set to stay that way.

Consequences

The 2008 financial crash had major implications around the world. It generated a recession, and many countries began to cut public spending, pursuing policies of austerity in the view that it was reckless spending and profligacy that had caused the crash in the first place.

Housing and the mortgage market was one of the most obviously impacted sectors. Mortgages became much more difficult to obtain, with thorough checks and strict limits being placed on them – a sharp contrast to the happy-go-lucky policies of the 1990s and 2000s. Housing prices dropped dramatically as a result. Many of those who had taken out mortgages prior to 2008 faced foreclosure.

Unemployment soared in many countries to levels previously seen in the Great Depression as credit and expenditure tightened. New practices and regulations for banks were introduced across the world by regulators in an attempt to ensure that there was a framework should any future crises arise.

Sarah Roller

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