Global Financial Crisis

Context/Description: Following the dot-com bust, the Federal Reserve lowered interest rates to historic lows (1% by 2003) to stimulate the economy. This cheap money flowed into real estate. U.S. housing became a speculative asset class. Financial innovation created complex mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). Subprime mortgages—loans to borrowers with poor credit—were packaged into securities rated AAA by agencies paid by issuers. Lenders offered "NINJA loans" (No Income, No Job, No Assets verified) and adjustable-rate mortgages with low "teaser rates." Investment banks leveraged 30:1 or more, holding toxic assets. The shadow banking system (non-bank financial institutions) grew massive and unregulated.

Warning Signs (Visible Years Before the Crash):

• Housing price-to-income ratios reached record highs by 2005
• Median home prices in bubble markets (California, Florida, Nevada) rose 100-200% in 5 years
• Subprime mortgage origination exploded to 20% of all mortgages
• Mortgage fraud became rampant; stated-income loans proliferated
• Subprime defaults began rising in 2006
• New Century Financial (major subprime lender) bankruptcy in March 2007
• Bear Stearns hedge funds collapsed in July 2007 due to subprime exposure
• Northern Rock bank run in UK (September 2007)—first British bank run in 150 years
• Credit markets freezing in August 2007; LIBOR-OIS spreads widening
• Home prices peaked mid-2006 and began declining
• Inventory of unsold homes surging
• Analysts and investors (Michael Burry, Steve Eisman, others) publicly warning of crisis

The Problem: A housing bubble was inflated by predatory lending, fraudulent appraisals, and the false assumption that home prices never decline nationally. Subprime mortgages were repackaged into securities that hid their risk. Rating agencies gave AAA ratings to junk. Global financial institutions held these "toxic assets" without understanding their content. Excessive leverage meant small losses caused insolvency. The system was interconnected through derivatives (especially credit default swaps), creating systemic risk.

The Trigger: Rising interest rates caused adjustable-rate mortgages to reset higher. Homeowners defaulted. Housing prices fell. Mortgage-backed securities became "toxic"—no one knew their true value. Bear Stearns collapsed in March 2008 (shotgun marriage to JPMorgan with Fed backing). Confidence eroded through summer 2008.

On September 15, 2008, Lehman Brothers—a 158-year-old investment bank—filed for bankruptcy with $600 billion in assets. The government chose not to bail it out (after Bear Stearns and Fannie/Freddie rescues). This decision shocked markets.

The Cascade: Complete credit market freeze:

• Lehman's collapse created panic—no one knew who held toxic assets
• Interbank lending stopped; banks hoarded cash
• Money market funds "broke the buck"—failed to maintain $1 share value
• AIG, the insurance giant, needed an $85 billion bailout (ultimately $182 billion)
• Washington Mutual: largest bank failure in U.S. history
• Wachovia forced into merger
• Stock markets crashed globally
• General Motors and Chrysler required bailouts
• Credit cards and auto loans unavailable
• Commercial paper market froze—companies couldn't fund operations
• Developing countries saw capital flight

Results/Impacts: The worst crisis since the Great Depression:

• U.S. stock markets fell approximately 50% (peak to trough)
• Housing prices fell 30% nationally (50%+ in bubble markets)
• Unemployment reached 10% officially (underemployment much higher)
• 8.7 million jobs lost
• $9.8 trillion in household wealth destroyed
• Global GDP declined 15% in inflation-adjusted terms
• $10-15 trillion in total global losses (estimates vary)
• Deepest global recession since WWII
• European sovereign debt crisis followed (Greece, Ireland, Portugal, Spain)
• Rising inequality and political polarization

Government Response:

• TARP: $700 billion bank bailout (Troubled Asset Relief Program)
• Federal Reserve interventions: Zero interest rates, quantitative easing (buying bonds)
• Auto industry bailouts
• Stimulus packages: American Recovery and Reinvestment Act ($831 billion)
• International coordination: G20 actions, central bank cooperation

Regulatory Reforms:

• Dodd-Frank Act (2010): Consumer Financial Protection Bureau, stress tests for banks, Volcker Rule limiting proprietary trading, derivatives regulation
• Basel III: Higher bank capital requirements
• Too Big to Fail addressed (partially)

Long-Term Effects:

• Central banks adopted unconventional monetary policy (QE became standard)
• Inequality widened dramatically
• Political upheaval: Tea Party, Occupy Wall Street, populist movements
• Trust in institutions declined
• Homeownership rates fell
• Millennial generation scarred financially
• Debates over capitalism and regulation intensified

The Lesson: Financial innovation without regulation creates systemic risk. Leverage amplifies disasters. "Too big to fail" creates moral hazard but letting giants fail causes panic. Rating agencies have conflicts of interest. Fraud and predatory lending must be prosecuted. Interconnected global finance requires international coordination. The crisis was predictable and predicted—but warnings were ignored because too many profited from the bubble.