The 2007-2008 financial crisis originated from the collapse of the U.S. housing market, which led to severe liquidity contraction across global financial markets. This crisis threatened the international financial system, resulting in the bankruptcy or near-bankruptcy of numerous major investment banks, commercial banks, mortgage lenders, insurance companies, and savings and loan associations. It also triggered the Great Recession (2007-2009), the most severe economic downturn since the Great Depression (1929-1939).

Causes of the Crisis

1. Monetary Policy and Interest Rates: The Federal Reserve (Fed) anticipated a mild economic recession beginning in 2001 and thus reduced the federal funds rate (the overnight borrowing rate between banks, based on balances held at the Federal Reserve) 11 times from May 2000 to December 2001, from 6.5% to 1.75%. This substantial reduction allowed banks to offer consumer credit at lower interest rates (known as "prime rates," which are typically 3 percentage points higher than the federal funds rate) and encouraged them to extend loans to "subprime" or high-risk borrowers, despite the higher interest rates associated with subprime loans. Consumers used this cheap credit to purchase durable goods, including appliances, cars, and especially homes, leading to the "housing bubble" of the late 1990s, where housing prices soared far beyond their fundamental values due to excessive speculation.
2. Regulatory Changes and Risky Lending: Changes in banking regulations during the 1980s allowed banks to offer subprime mortgages with features like balloon payments (exceptionally large repayments due at the end of the loan term) or adjustable rates (initially low, but fluctuating with the federal funds rate). As long as housing prices continued to rise, subprime borrowers could protect themselves from high mortgage payments by refinancing, using the home’s appreciation as collateral, or selling the home at a profit. In cases of default, banks could repossess properties and sell them for more than the original loan amount. Consequently, subprime loans became a profitable investment for many banks, leading them to aggressively market these loans to borrowers with poor credit or limited assets, often misleading them about the associated risks. As a result, subprime mortgages increased from about 2.5% of all home loans in the late 1990s to nearly 15% from 2004 to 2007.
3. Securitization: The widespread implementation of securitization contributed to the growth of subprime mortgages. In this process, banks bundled hundreds or even thousands of subprime mortgages and other low-risk consumer debts into securities (bonds) and sold them on the capital markets to other banks and investors, including hedge funds and pension funds. Bonds primarily composed of mortgages are known as mortgage-backed securities (MBS), with buyers entitled to a portion of the interest and principal from the underlying loans. Selling subprime mortgages as MBS was seen as a way for banks to increase liquidity and reduce exposure to high-risk loans, while purchasing MBS was viewed as a method for banks and investors to diversify portfolios and generate profits. As housing prices continued to surge in the early 21st century, MBS became highly popular, and their prices in the capital markets also increased.
4. Deregulation and Capital Requirements: In 1999, the partial repeal of the Glass-Steagall Act (1933), which had been in place since the Great Depression, allowed banks, securities firms, and insurance companies to enter each other’s markets and merge, leading to the creation of "too big to fail" institutions (those whose failure could threaten the entire financial system). Additionally, in 2004, the Securities and Exchange Commission (SEC) lowered net capital requirements (the ratio of capital or assets to liabilities that banks must maintain to avoid bankruptcy), encouraging banks to invest more in MBS. While this decision generated substantial profits for banks, it also exposed their portfolios to significant risks, as the value of MBS was implicitly dependent on the continuation of the housing bubble.
5. Overconfidence and Regulatory Lapses: Before the crisis, the global economy had enjoyed long-term stability and growth starting in the mid-1980s, a period referred to as the "Great Moderation." This led many American bank executives, government officials, and economists to believe that extreme economic fluctuations were a thing of the past. This overconfidence, combined with an ideological emphasis on deregulation and the self-regulation capabilities of financial firms, led to a widespread disregard or underestimation of the obvious signs of an impending crisis. Consequently, bankers continued to engage in reckless lending and securitization activities.

Key Events of the Financial Crisis

1. Subprime Mortgage Crisis (2007): The U.S. housing market began to collapse due to a large number of high-risk subprime mortgage defaults. Subprime mortgages are loans extended to borrowers with poor credit histories. The surge in defaults led to a decline in housing prices, resulting in severe losses for financial institutions.
2. Lehman Brothers Bankruptcy (September 15, 2008): Lehman Brothers, the fourth-largest investment bank globally, declared bankruptcy, marking the largest bankruptcy in U.S. history. This triggered market panic and led to a sharp decline in financial markets.
3. AIG Bailout (September 16, 2008): The U.S. government intervened with an $85 billion bailout for American International Group (AIG), which held substantial amounts of subprime-related financial products. AIG’s failure threatened the global financial system.
4. Stock Market Crash (September-October 2008): Major global stock markets experienced severe declines. Investor confidence in the stability of the financial system eroded, leading to a dramatic reduction in stock prices.
5. Emergency Legislation (October 3, 2008): The U.S. Congress passed the Emergency Economic Stabilization Act, authorizing $700 billion to purchase toxic assets and provide bank system relief, aimed at restoring financial market stability.
6. Global Financial Turmoil (Fall 2008): The financial crisis spread globally, affecting banking systems and financial markets in many countries. Several nations implemented similar bailout measures to address financial instability.
7. Financial Institution Restructuring and Consolidation (2008 and Beyond): In response to the crisis, numerous financial institutions underwent restructuring, mergers, or acquisitions. For instance, Bear Stearns was acquired by JPMorgan Chase, and other large banks also engaged in consolidation or mergers.

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