The immediate or proximate cause of the crisis in 2008 was the failure or risk of failure at major financial institutions globally, starting with the rescue of investment bank Bear Stearns in March 2008 and the failure of Lehman Brothers in September 2008. Many of these institutions had invested heavily in risky securities that lost much or all of their value when U.S. and European housing bubbles began to deflate during the 2007-2009 period. Further, many institutions had become dependent on short-term (overnight) funding markets subject to disruption.
The origin of these housing bubbles involved two major factors: 1) low interest rates in the U.S. and Europe following the 2000-2001 U.S. recession; and 2) significant growth in savings available from developing nations due to ongoing trade imbalances. These factors drove a large increase in demand for high-yield investments. Large investment banks connected the housing markets to this large supply of savings via innovative new securities, fueling housing bubbles in the U.S. and Europe.
Many institutions lowered credit standards to continue feeding the global demand for mortgage securities, generating huge profits while passing the risk to investors. However, while the bubbles developed, household debt levels rose sharply after the year 2000 globally. Households became dependent on being able to refinance their mortgages. Further, U.S. households often had adjustable rate mortgages, which had lower initial interest rates and payments that later rose. When global credit markets essentially stopped funding mortgage-related investments in the 2007-2008 period, U.S. homeowners were no longer able to refinance and defaulted in record numbers, leading to the collapse of securities backed by these mortgages that now pervaded the system.
The failure rates of subprime mortgages were the first symptom of a credit boom turned to bust and of a real estate shock. But large default rates on subprime mortgages cannot account for the severity of the crisis. Rather, low-quality mortgages acted as an accelerant to the fire that spread through the entire financial system. The latter had become fragile as a result of several factors that are unique to this crisis: the transfer of assets from the balance sheets of banks to the markets, the creation of complex and opaque assets, the failure of ratings agencies to properly assess the risk of such assets, and the application of fair value accounting. To these novel factors, one must add the now standard failure of regulators and supervisors in spotting and correcting the emerging weaknesses.
By 2007, real estate bubbles were still under way in many parts of the world, especially in the United States, France, United Kingdom, Italy, Spain, The Netherlands, Australia, United Arab Emirates, New Zealand, Ireland, Poland, South Africa, Israel, Greece, Bulgaria, Croatia, Norway, Singapore, South Korea, Sweden, Finland, Argentina, Baltic states, India, Romania, Ukraine, and China. U.S. Federal Reserve Chairman Alan Greenspan said in mid-2005 that “at a minimum, there’s a little ‘froth’ [in the U.S. housing market]…it’s hard not to see that there are a lot of local bubbles”.
The Economist magazine, writing at the same time, went further, saying “the worldwide rise in house prices is the biggest bubble in history”. Real estate bubbles are (by definition of the word “bubble”) followed by a price decrease (also known as a housing price crash) that can result in many owners holding negative equity (a mortgage debt higher than the current value of the property).
During 2008, three of the largest U.S. investment banks either went bankrupt (Lehman Brothers) or were sold at fire sale prices to other banks (Bear Stearns and Merrill Lynch). The investment banks were not subject to the more stringent regulations applied to depository banks. These failures augmented the instability in the global financial system. The remaining two investment banks, Morgan Stanley and Goldman Sachs, potentially facing failure, opted to become commercial banks, thereby subjecting themselves to more stringent regulation but receiving access to credit via the Federal Reserve.