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 theUnited 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
investmentbanking 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.
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-calledsubprime 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 theforeclosure 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 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 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.

In December 2008, as the global financial crisis deepens, a store in New York City advertises that …
Mark Lennihan/AP
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The next victim, in March, was theWall 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 byJPMorgan 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.

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
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 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 1977Community
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.
TheReserve 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.
International Repercussions
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 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 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. InGreece
street riots in December reflected, among other things, anger with economic
stagnation. Iceland found itself essentially bankrupt, withHungary 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, andSouth 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,
loosing a cascade of misfortune. The ensuing collapse lasted four years.