The 2008 Financial Crisis: How Subprime Mortgages Crashed the Global Banking System

The Roots: The Housing Boom and Easy Credit

It all began with Federal Reserve policy following the dot-com bubble and 9/11: record-low interest rates (1% in 2003-2004) to stimulate the economy. Abundant credit flooded into the American housing market.

The subprime mortgage problem: Banks began granting mortgages to people with low repayment capacity (subprime) using increasingly aggressive practices:

• NINJA loans (No Income, No Job, No Assets)
• Teaser rates that reset to higher adjustable rates (ARM - Adjustable Rate Mortgage)
• 100% loan-to-value or higher (mortgages exceeding the home's value)
• No verification of declared income

Why did banks accept such high risks? Because they did not keep the mortgages on their balance sheets.

The Securitization Machine

This is the heart of the disaster. Banks bundled thousands of mortgages, 'packaged' them into financial instruments called MBS (Mortgage-Backed Securities), and sold them to investors worldwide.

These MBS were then further combined into CDOs (Collateralized Debt Obligations), structures so complex that almost no one could understand the real risk. Rating agencies (Moody's, S&P, Fitch) assigned AAA ratings to products containing high-risk mortgages.

The mechanism created a perfect moral hazard: banks had no incentive to verify the creditworthiness of borrowers, because the risk was immediately transferred to others.

The Chain Reaction Breaks (2007-2008)

2006: US home prices began to fall for the first time since the post-war period 2007: ARM rates reset higher, subprime mortgage defaults exploded June 2007: Bear Stearns had two hedge funds exposed to CDOs that collapsed August 2007: The interbank market froze — banks stopped lending money to each other March 2008: Bear Stearns was rescued by JP Morgan with a Fed guarantee (at $2 per share, down from $170)

Monday, September 15, 2008: Lehman Brothers Fails

Lehman Brothers, the fourth-largest American investment bank, with $639 billion in assets and 25,000 employees, filed for bankruptcy on September 15, 2008 — the largest corporate failure in American history.

Unlike Bear Stearns, the US government decided not to intervene. It was a choice that changed history: panic spread throughout the global financial system.

The following days:

• Merrill Lynch sold in an emergency deal to Bank of America
• AIG (the world's largest insurer) bailed out with $85 billion in government funds
• The money market froze — money market funds 'broke the buck'
• The US Congress passed TARP: $700 billion to save the banks

The Global Impact

Financial Markets:

• S&P 500: -57% from the peak (2007-2009)
• Global equity value wiped out: $30 trillion

Real Economy:

• USA: -4.3% GDP, 10% unemployment
• Eurozone: -4.5%, 20 million unemployed
• World trade: -12% in 2009
• 8 million Americans lost their homes

The Response: Quantitative Easing and Bailouts

Ben Bernanke's Fed lowered interest rates to zero and launched unprecedented asset purchase programs (QE). Governments worldwide injected trillions into their banks.

The system survived, but at a massive cost: public debt exploded across the West, and trust in financial institutions was permanently damaged.

The Lessons

1. Risk does not disappear when it is transferred: securitization distributed risk but did not eliminate it
2. Rating agencies have conflicts of interest: they are paid by the issuers of the products they are meant to evaluate
3. Systemic leverage is the enemy: when all banks use high leverage, the entire system is fragile
4. 'Too big to fail' is a governance problem: bailouts privatize profits and socialize losses