The global financial crisis of 2007 to 2009 was the most serious financial crisis since the Great Depression. It began in the US housing market, spread through complex financial products to banks around the world and triggered a deep global recession. In Part 16 of Great Financial Crises, we explain what happened and what changed.
The housing boom
After the dot-com bust (Part 14), the Federal Reserve kept interest rates low. Mortgage rates fell, house prices rose, and lenders competed fiercely for business. Lending standards loosened dramatically. "Subprime" loans were made to borrowers with weak credit, often with low initial "teaser" rates that would later reset higher. Some loans required little proof of income.
Many people believed house prices would keep rising, so even risky loans seemed safe: if a borrower struggled, the home could be sold or refinanced at a higher value.
Securitisation and leverage
Banks did not keep most of these mortgages. They bundled them into mortgage-backed securities and more complex products called collateralised debt obligations (CDOs), which were sold to investors around the world. Credit rating agencies gave many of these products top AAA ratings.
Banks and investment banks borrowed heavily to buy these assets, often funding long-term holdings with short-term loans. Insurer AIG sold large amounts of credit default swaps, a form of insurance on these securities, without holding enough capital to pay if they failed.
The bust
US house prices peaked around 2006. As teaser rates reset and prices fell, defaults soared. According to the Federal Reserve's history essay, home prices fell about 30% on average from mid-2006 to mid-2009. Securities tied to mortgages lost value, and because no one knew exactly who held the losses, banks stopped trusting each other.
Timeline of the panic
- 2007: mortgage lenders failed and interbank lending markets came under strain.
- March 2008: investment bank Bear Stearns, near collapse, was sold to JPMorgan Chase with Federal Reserve support.
- 7 September 2008: mortgage giants Fannie Mae and Freddie Mac, which owned or guaranteed about $5 trillion in home loans, were placed in government conservatorship.
- 15 September 2008: Lehman Brothers filed for bankruptcy, the largest in US history, with more than $600 billion in debts. Merrill Lynch agreed to be sold to Bank of America the same weekend.
- 16 to 17 September 2008: the government took control of AIG in an $85 billion rescue. A large money market fund "broke the buck," falling below $1 per share, triggering runs on money funds.
- 3 October 2008: President George W. Bush signed the Troubled Asset Relief Program (TARP), authorising up to $700 billion. Treasury used it to inject capital into banks.
The policy response
According to the Fed's history essay:
- The Fed cut its policy rate from 5.25% in September 2007 to near zero (0% to 0.25%) by December 2008.
- It created emergency lending programmes for banks, money market funds and other markets.
- It began large-scale asset purchases, known as quantitative easing (QE). The first round totalled about $1.75 trillion of longer-term securities.
- Congress passed stimulus packages in 2008 and 2009.
Governments and central banks around the world took similar steps, and the G20 coordinated responses.
The damage
- The US recession lasted from December 2007 to June 2009, the longest since World War II.
- Real GDP fell 4.3%, the largest decline of the post-war period.
- Unemployment rose from 5% to a peak of 10% in October 2009.
- The S&P 500 fell 57% from October 2007 to March 2009.
- US household net worth fell from about $69 trillion in 2007 to about $55 trillion in 2009.
- Millions of Americans lost their homes to foreclosure.
Reforms
- Dodd-Frank Act (2010): created the Consumer Financial Protection Bureau, introduced stress tests for large banks and new rules for derivatives.
- Basel III: international rules requiring banks to hold more and higher-quality capital and liquid assets.
- Resolution planning: large banks must prepare "living wills" for orderly failure.
Lessons for investors today
- "Safe" assets can be risky. AAA ratings did not protect investors from losses.
- Leverage and short-term funding are dangerous combinations, as LTCM had shown in 1998 (Part 13).
- House prices can fall nationally. Many models assumed they would not.
- Staying invested paid off. Investors who held diversified portfolios through the crash eventually recovered and gained, while those who sold near the bottom locked in losses.
In Part 17, we look at how the crisis brought down Iceland's entire banking system in a matter of days.
Sources
- Federal Reserve History – The Great Recession and Its Aftermath
- Fox Business – Key events of the financial crisis, years after Lehman
Great Financial Crises: the full series
- Part 1: Tulip Mania (1637)
- Part 2: The Mississippi and South Sea Bubbles (1720)
- Part 3: The Panic of 1907
- Part 4: The Wall Street Crash and Great Depression
- Part 5: Weimar Hyperinflation (1923)
- Part 6: The 1970s Oil Shocks and Stagflation
- Part 7: The Latin American Debt Crisis (1982)
- Part 8: Black Monday (1987)
- Part 9: Japan's Bubble and Lost Decades
- Part 10: The Savings and Loan Crisis
- Part 11: The Mexican Peso Crisis (1994)
- Part 12: The Asian Financial Crisis (1997)
- Part 13: Russia's Default and LTCM (1998)
- Part 14: The Dot-Com Bubble (2000)
- Part 15: Argentina's Collapse (2001)
- Part 16: The Global Financial Crisis (2008) (you are here)
- Part 17: Iceland's Banking Collapse (2008)
- Part 18: The Eurozone Debt Crisis
- Part 19: The Covid Crash (2020)
- Part 20: The 2023 Banking Turmoil
This series is for education only and is not investment advice. Figures are taken from the sources listed and other commonly cited historical records, and may vary slightly between sources.
