Financial crisis of 2007–2008

The financial crisis of 2008, also known as the global financial crisis
(GFC), was a severe worldwide economic crisis. Prior to the COVID-19
recession in 2020, it was considered by many economists to have been the
most serious financial crisis since the Great Depression. Predatory lending
targeting low-income homebuyers, excessive risk-taking by global financial
institutions, and the bursting of the United States housing bubble
culminated in a "perfect storm". Mortgage-backed securities (MBS) tied to
American real estate, as well as a vast web of derivatives linked to those
MBS, collapsed in value. Financial institutions worldwide suffered severe
damage, reaching a climax with the bankruptcy of Lehman Brothers on
September 15, 2008, and a subsequent international banking crisis.

Effect

The crisis sparked the Great Recession, which, at the time, was the most
severe global recession since the Great Depression. It was also followed by
the European debt crisis, which began with a deficit in Greece in late 2009,
and the 2008–2011 Icelandic financial crisis, which involved the bank
failure of all three of the major banks in Iceland and, relative to the size of
its economy, was the largest economic collapse suffered by any country
in history. It was among the five worst financial crises the world had
experienced and led to a loss of more than $2 trillion from the global
economy. U.S. home mortgage debt relative to GDP increased from an
average of 46% during the 1990s to 73% during 2008, reaching $10.5
trillion.
Lack of investor confidence in bank solvency and declines in credit
availability led to plummeting stock and commodity prices in late 2008 and
early 2009.The crisis rapidly spread into a global economic shock, resulting
in several bank failures. Economies worldwide slowed during this period
since credit tightened and international trade declined. Housing markets
suffered and unemployment soared, resulting in evictions and foreclosures.
Several businesses failed.

The average hours per work week declined to 33, the lowest level since the
government began collecting the data in 1964.

As part of national fiscal policy response to the Great Recession,

governments and central banks, including the Federal Reserve, the European
Central Bank and the Bank of England, provided then-unprecedented
trillions of dollars in bailouts and stimulus, including expansive fiscal
policy and monetary policy to offset the decline in consumption and
lending capacity, avoid a further collapse, encourage lending, restore faith in
the integral commercial paper markets, avoid the risk of a deflationary
spiral, and provide banks with enough funds to allow customers to make
withdrawals

Bailouts came in the form of trillions of dollars of loans, asset purchases,

guarantees, and direct spending. Significant controversy accompanied the
bailouts, such as in the case of the AIG bonus payments controversy,
leading to the development of a variety of "decision making frameworks",
to help balance competing policy interests during times of financial crisis.
Alistair Darling, the U.K.'s Chancellor of the Exchequer at the time of the
crisis, stated in 2018 that Britain came within hours of "a breakdown of law
and order" the day that Royal Bank of Scotland was bailed-out.
Instead of financing more domestic loans, some banks instead spent some of
the stimulus money in more profitable areas such as investing in emerging
markets and foreign currencies.

Causes

While the causes of the bubble are disputed, the precipitating factor for the
Financial Crisis of 2007–2008 was the bursting of the United States
housing bubble and the subsequent subprime mortgage crisis, which
occurred due to a high default rate and resulting foreclosures of mortgage
loans, particularly adjustable-rate mortgages. Some or all of the following
factors contributed to the crisis:

Government mandates forced banks to extend loans to borrowers

previously considered uncreditworthy, leading to increasingly lax
underwriting standards and high mortgage approval rates. These, in turn,
led to an increase in the number of homebuyers, which drove up housing
prices. This appreciation in value led many homeowners to borrow against
the equity in their homes as an apparent windfall, leading to over-
leveraging.
The high delinquency and default rates by homeowners, particularly
those with subprime credit, led to a rapid devaluation of mortgage-backed
securities including bundled loan portfolios, derivatives and credit default
swaps. As the value of these assets plummeted, buyers for these securities
evaporated and banks who were heavily invested in these assets began to
experience a liquidity crisis.
Securitization allowed for shifting of risk and lax underwriting
standards: Many mortgages were bundled together and formed into new
financial instruments called mortgage-backed securities, in a process
known as securitization. These bundles could be sold as (ostensibly) low-
risk securities partly because they were often backed by credit default
swaps insurance. Because mortgage lenders could pass these mortgages
(and the associated risks) on in this way, they could and did adopt loose
underwriting criteria.
Lax regulation allowed predatory lending in the private sector, especially
after the federal government overrode anti-predatory state laws in 2004.

The Community Reinvestment Act(CRA), a 1977 U.S. federal law

designed to help low- and moderate-income Americans get mortgage loans
required banks to grant mortgages to higher risk families.

Reckless lending by lenders such as Bank of America's Countrywide

Financialunit was increasingly incentivized and even mandated by
government regulation. This may have caused Fannie Maeand Freddie
Macto lose market share and to respond by lowering their own standards.

Mortgage guarantees by Fannie Mae and Freddie Mac, quasi-

government agencies, which purchased many subprime loan
securitizations. The implicit guarantee by the U.S. federal government
created a moral hazard and contributed to a glut of risky lending.
Government policies that encouraged home ownership, providing
easier access to loans for subprime borrowers; overvaluation of bundled
subprime mortgages based on the theory that housing prices would
continue to escalate; questionable trading practices on behalf of both
buyers and sellers; compensation structures by banks and mortgage
originators that prioritize short-term deal flow over long-term value
 creation; and a lack of adequate capital holdings from banks and
insurance companies to back the financial commitments they were
making.

The Wall Street and the Financial Crisis: Anatomy of a Financial

Collapse (Levin–Coburn Report) by the United States Senate concluded
that the crisis was the result of "high risk, complex financial products;
undisclosed conflicts of interest; the failure of regulators, the credit rating
agencies, and the market itself to rein in the excesses of Wall Street".

Analysis of causes
Role of affordable housing programs
Governmental policies had some role in causing the crisis, they contend that
GSE loans performed better than loans securitized by private investment
banks, and performed better than some loans originated by institutions that
held loans in their own portfolios.

Growth of the housing bubble

This housing bubble resulted in many homeowners refinancing their homes

at lower interest rates, or financing consumer spending by taking out
second mortgages secured by the price appreciation.

Easy credit conditions

Lower interest rates encouraged borrowing. From 2000 to 2003, the Federal
Reserve lowered the federal funds rate target from 6.5% to 1.0%. This was
done to soften the effects of the collapse of the dot-com bubble and the
September 11 attacks, as well as to combat a perceived risk of deflation. As
early as 2002, it was apparent that credit was fueling housing instead of
business investment as some economists went so far as to advocate that the
Fed "needs to create a housing bubble to replace the Nasdaq bubble”.
Moreover, empirical studies using data from advanced countries show that
excessive credit growth contributed greatly to the severity of the crisis.

Weak and fraudulent underwriting practices

Subprime lending standards declined in the U.S.: in early 2000, a subprime
borrower had a FICO score of 660 or less. By 2005, many lenders dropped
the required FICO score to 620, making it much easier to qualify for prime
loans and making subprime lending a riskier business. Proof of income and
assets were de-emphasized. Loans at first required full documentation, then
low documentation, then no documentation. One subprime mortgage product
that gained wide acceptance was the no income, no job, no asset verification
required (NINJA) mortgage.
Predatory lending
Predatory lending refers to the practice of unscrupulous lenders, enticing
borrowers to enter into "unsafe" or "unsound" secured loans for
inappropriate purposes.

Deregulation and lack of regulation

According to Barry Eichen green, the roots of the financial crisis lay in the
deregulation of financial markets. A 2012 OECD study ] suggest that bank
regulation based on the Basel accords encourage unconventional business
practices and contributed to or even reinforced the financial crisis. In other
cases, laws were changed or enforcement weakened in parts of the financial
system.
Increased debt burden or overleveraging

Prior to the crisis, financial institutions became highly leveraged, increasing

their appetite for risky investments and reducing their resilience in case of
losses. Much of this leverage was achieved using complex financial
instruments such as off-balance sheet securitization and derivatives, which
made it difficult for creditors and regulators to monitor and try to reduce
financial institution risk levels.

Financial innovation and complexity

The term financial innovation refers to the ongoing development of financial

products designed to achieve particular client objectives, such as offsetting a
particular risk exposure (such as the default of a borrower) or to assist with
obtaining financing. Examples pertinent to this crisis included: the
adjustable-rate mortgage; the bundling of subprime mortgages into
mortgage-backed securities (MBS) or collateralized debt obligations(CDO)
for sale to investors, a type of securitization; and a form of credit insurance
called credit default swaps (CDS). The usage of these products expanded
dramatically in the years leading up to the crisis. These products vary in
complexity and the ease with which they can be valued on the books of
financial institutions.

Incorrect pricing of risk

Mortgage risks were underestimated by almost all institutions in the chain

from originator to investor by underweighting the possibility of falling
housing prices based on historical trends of the past 50 years. Limitations of
default and prepayment models, the heart of pricing models, led to
overvaluation of mortgage and asset-backed products and their derivatives
by originators, securitizers, broker-dealers, rating-agencies, insurance
underwriters and the vast majority of investors (with the exception of certain
hedge funds.

Boom and collapse of the shadow banking system

There is strong evidence that the riskiest, worst performing mortgages were
funded through the "shadow banking system" and that competition from the
shadow banking system may have pressured more traditional institutions to
lower their underwriting standards and originate riskier loans.

Commodity price inflation

Rapid increases in several commodity prices followed the collapse in the
housing bubble. The price of oil nearly tripled from $50 to $147 from early
2007 to 2008, before plunging as the financial crisis began to take hold in
late 2008.

Wrong banking model: resilience of credit unions

A report by the International Labour Organization concluded that
cooperative banking institutions information that is likely to ruin their firm,
and possibly the whole economy.