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The 2008 Financial Crisis Explained
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# The 2008 Financial Crisis Explained

By

Manoj Singh has 29+ years of experience working for the Central Bank of India. He is the author of Bulls, Bears, and the Tortoise.

Updated August 25, 2024

Reviewed by

Reviewed byThomas J. Catalano

Thomas J Catalano is a CFP and Registered Investment Adviser with the state of South Carolina, where he launched his own financial advisory firm in 2018. Thomas' experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning.

Fact checked by

Fact checked byPete Rathburn

Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom.

Part of the Series

Guide to Stock Market Crashes

What Happens in a Crash

Early Crashes

Crash of 1929

Crash of 1987

The Great Recession and Beyond

The 2008 financial crisis was years in the making. A reckoning was due for a years-long binge fueled by cheap credit. In mid-2007, two Bear Stearns hedge funds collapsed, BNP Paribas was warning investors that they might not be able to withdraw money from three of its funds, and the British bank Northern Rock was poised to seek emergency funding from the Bank of England.

That was just the beginning. Few investors suspected that the worst crisis in nearly eight decades was about to engulf the global financial system, bringing Wall Street's giants to their knees and triggering the Great Recession.

The 2008 financial crisis was an epic financial and economic collapse that cost many ordinary people their jobs, their life savings, their homes, or all three.

### Key Takeaways

- The 2008 financial crisis developed gradually. Home prices began to fall in early 2006.
- Subprime lenders began to file for bankruptcy in early 2007.
- Two big hedge funds failed in June 2007, weighed down by investments in subprime loans.
- Losses from subprime loan investments caused a panic that froze the global lending system in August 2007.
- In September 2008, Lehman Brothers collapsed in the biggest U.S. bankruptcy ever.

## Sowing the Seeds of the Crisis

The seeds of the financial crisis were planted during years of historically low interest rates and loose lending standards that fueled a housing price bubble in the U.S. and elsewhere. It began, as usual, with good intentions.

Faced with the bursting of the dot-com bubble, a series of corporate accounting scandals, and the September 11 terrorist attacks, the Federal Reserve lowered the federal funds rate from 6.5% in May 2000 to 1% in June 2003.

The aim was to boost the economy by making money available to businesses and consumers at bargain rates. The result was an upward spiral in home prices as borrowers took advantage of low mortgage rates to buy homes. Even subprime borrowers with poor or no credit history were able to buy homes, often at prices that were well beyond their ability to repay.

The 2008 financial crisis began with cheap credit and lax lending standards that fueled a housing price bubble. The low-quality loans were packaged and resold to financial institutions as investments. When the bubble burst, the institutions were left holding trillions of dollars of worthless mortgages.

### The Subprime Loan Boom

Even in normal times, banks do not often hold onto the mortgages they issue. They are resold to financial institutions, which market them as investments in interest payments.

During the housing bubble, the banks sold these loans to the big Wall Street banks, which re-packaged and marketed them as low-risk financial instruments such as mortgage-backed securities and collateralized debt obligations (CDOs). A big secondary market for originating and distributing subprime loans soon developed.

The Securities and Exchange Commission (SEC) in October 2004 relaxed the net capital requirements for five investment banks in 2004: Goldman Sachs (NYSE: GS), Merrill Lynch (NYSE: MER), Lehman Brothers, Bear Stearns, and Morgan Stanley (NYSE: MS).

This fueled greater risk-taking among banks and freed them to leverage their initial investments by 30 times or even 40 times.

## Signs of Trouble

Interest rates eventually started to rise and the housing market reached a saturation point. The Fed started raising rates in June 2004 and the federal funds rate reached 5.25% two years later, where it remained until August 2007.

There were early signs of distress. U.S. homeownership had peaked at 69.2% by 2004. Then home prices started to fall in early 2006.

This caused real hardship to many Americans. Their homes were worth less than what they had paid for them. They couldn't sell without owing money to their lenders. If they had adjustable-rate mortgages, their costs were going up as their homes' values were going down.

The most vulnerable subprime borrowers were stuck with mortgages they couldn't afford in the first place.

Subprime mortgage company New Century Financial made nearly $60 billion in loans in 2006. It filed for bankruptcy protection in 2007.

One subprime lender after another filed for bankruptcy as 2007 got underway. More than 25 subprime lenders went under during February and March alone. New Century Financial, which specialized in sub-prime lending, filed for bankruptcy and laid off half of its workforce in April.

Bear Stearns stopped redemptions in two of its hedge funds in June 2007. Early in March 2008, the Bear Stearns name disappeared after the company was acquired by JPMorgan Chase.

But even these were small matters compared to what was to happen in the months ahead.

## August 2007: The Dominoes Start to Fall

It became apparent by August 2007 that the financial markets couldn't solve its subprime crisis and that the problems it caused were reverberating well beyond the U.S. borders.

The interbank market that keeps money flowing around the globe froze completely, largely due to fear of the unknown. Northern Rock had to approach the Bank of England for emergency funding to keep operating. In October 2007, Swiss bank UBS became the first major bank to announce losses from subprime-related investments totaling $3.4 billion.

The Federal Reserve and other central banks would take coordinated action to provide billions of dollars in loans to the global credit markets in the coming months.

The markets were grinding to a halt as asset prices fell. Financial institutions struggled to assess the value of the trillions of dollars worth of now-toxic mortgage-backed securities that were sitting on their books.

## March 2008: The Demise of Bear Stearns

The U.S. economy was in a full-blown recession by the winter of 2008. Stock markets around the world were tumbling more than they had since the September 11, 2001, terrorist attacks.

The Fed cut its benchmark rate by three-quarters of a percentage point in January 2008. This was its biggest cut in a quarter-century as it sought to slow the economic slide.

The bad news continued to pour in from all sides. The British government was forced to nationalize Northern Rock in February. Global investment bank Bear Stearns, a pillar of Wall Street that dated to 1923, collapsed and was acquired by JPMorgan Chase for pennies on the dollar in March 2008.

## September 2008: The Fall of Lehman Brothers

The carnage was spreading across the financial sector by the summer of 2008. IndyMac Bank became one of the largest banks ever to fail in the U.S. The country's two biggest home lenders, Fannie Mae and Freddie Mac, had been seized by the U.S. government.

The collapse of the venerable Wall Street bank Lehman Brothers in September marked the largest bankruptcy in U.S. history and it became for many a symbol of the devastation caused by the global financial crisis.

Financial markets were in free fall in September with the major U.S. indexes suffering some of their worst losses on record. The Fed, the Treasury Department, the White House, and Congress struggled to put forward a comprehensive plan to stop the bleeding and restore confidence in the economy.

## The Aftermath

The Wall Street bailout package was approved in the first week of October 2008.

The package included many measures, such as a huge government purchase of "toxic assets," an enormous investment in bank stock shares, and financial lifelines for Fannie Mae and Freddie Mac.

Public indignation was widespread. It appeared that bankers were being rewarded for recklessly tanking the economy.

But it got the economy moving again. The investments in the banks were fully recouped by the government, with interest.

The passage of the bailout package stabilized the stock markets, which hit bottom in March 2009 and then embarked on the longest bull market in its history.

The government spent $440 billion through the Troubled Asset Relief Program (TARP). It got $442.6 billion back after assets bought in the crisis were resold at a profit.

The economic damage and human suffering were nonetheless immense. Unemployment reached 10%. About 3.8 million Americans lost their homes to foreclosures.

## About Dodd-Frank

The most ambitious and controversial attempt to prevent such an event from happening again was the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. The act restricted some of the riskier activities of the biggest banks, increased government oversight of their activities, and forced them to maintain larger cash reserves. It attempted to reduce predatory lending.

Some portions of the act were rolled back by the Trump Administration by 2018 although an attempt at a more wholesale dismantling of the new regulations failed in the U.S. Senate.

Those regulations are intended to prevent a crisis similar to the 2007–2008 event from happening again. But this doesn't mean that there won't be another financial crisis in the future. Bubbles have occurred periodically since the Dutch Tulip Bubble in the 1630s.

The 2007–2008 financial crisis was a global event. Ireland's vibrant economy fell off a cliff and Greece defaulted on its international debts. Portugal and Spain suffered from extreme levels of unemployment. Every nation's experience was different and complex.

## What Is a Mortgage-Backed Security?

A mortgage-backed security is similar to a bond. It consists of home loans that are bundled by the banks that issued them and then sold to financial institutions. Investors buy them to profit from the loan interest paid by the mortgage holders.

Loan originators encouraged millions to borrow beyond their means to buy homes they couldn't afford in the early 2000s. These loans were then passed on to investors in the form of mortgage-backed securities.

The homeowners who had borrowed beyond their means began to default. Housing prices fell and millions walked away from mortgages that cost more than their houses were worth.

## Who Is to Blame for the Great Recession?

There's plenty of blame to go around including:

- The predatory mortgage lenders who marketed loans to people who couldn't possibly repay them
- The investment gurus who bought those bad mortgages and rolled them into bundles for resale to investors
- The agencies who gave those mortgage bundles top investment ratings that made them appear to be safe
- The investors who knowingly bought bad loans to sell them on before they blew up

## Which Banks Failed in 2008?

More than 500 banks in the U.S. failed between 2008 and 2015, compared to a total of 25 in the preceding seven years, according to the Federal Reserve of Cleveland.

It's important to note that no depositor in an American bank lost a penny to a bank failure. In that respect, the system worked.

Most of the failed institutions were small regional banks, and all were acquired by other banks, along with their depositors' accounts.

The biggest failures weren't banks in the traditional Main Street sense but investment banks that catered to institutional investors. These notably included Lehman Brothers and Bear Stearns. Lehman Brothers was denied a government bailout and shut its doors. JPMorgan Chase bought the ruins of Bear Stearns on the cheap.

As for JPMorgan Chase, Goldman Sachs, Bank of America, and Morgan Stanley, they were all famously " too big to fail." They took the bailout money, repaid it to the government, and emerged bigger than ever after the recession.

## Who Made Money in the 2008 Financial Crisis?

Several smart investors made money from the crisis, mostly by picking up choice pieces from the wreckage.

- Warren Buffett invested billions in companies including Goldman Sachs and General Electric out of a mix of patriotism and profit.
- Hedge fund manager John Paulson made a lot of money betting against the U.S. housing market when the bubble formed and then made a lot more money betting on its recovery after it hit bottom.
- Investor Carl Icahn proved his market-timing talent by selling and buying casino properties before, during, and after the crisis.

## The Bottom Line

Bubbles occur continuously in the financial world. The price of a stock or any other commodity can become inflated beyond its intrinsic value.

The damage is usually limited to losses for a few over-enthusiastic buyers. The financial crisis of 2007–2008 was a different kind of bubble, however.

Like only a few others in history, it grew big enough that it damaged entire economies and hurt millions of people when it burst, most of whom weren't speculating in mortgage-backed securities.

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Part of the Series

Guide to Stock Market Crashes

What Happens in a Crash

Early Crashes

Crash of 1929

Crash of 1987

The Great Recession and Beyond

Take the Next Step to Invest

Advertiser Disclosure

×

The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.

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