The Global Financial Crisis of 2007-2010

Abstract

Because of the numerous causes of this event, the US recession and subsequent global financial crisis that began in 2007 has generated a great deal of academic and political interest in understanding its nature and how its repetition may be avoided in the future. This paper will cast a light on the roots of the 2007–2010 global financial crisis, its impacts, and the tools employed to bring it to a close.

Overview

Adherents to the familiar George Santayana axiom "Those who ignore history are condemned to repeat it" would find validation in the history of recessions in the United States. One of the worst recessions in US history took place when a land speculation bubble (an uncorrelated increase in prices) began to rapidly collapse upon itself. Banks, fearful of insolvency, suspended certain transactions, sending the economy into a severe recession that lasted for a year. This recession was at the time the worst recession the United States had ever experienced. More important, it was one of the first recessions in US history, commencing in 1797, less than ten years after the Constitution was ratified.

The "Panic of 1797," as it was known, would be succeeded by dozens of recessions over the course of the following two centuries. This list includes what most historians deem the worst recession in US history: the Great Depression of the 1930s. The first decade of the twenty-first century began with a severe recession, exacerbated by the horrific terrorist attacks on the World Trade Center and the Pentagon in 2001. Only a few years after that recession came to an end and the economy grew again, another recession began. This period, which began in 2007, resembled the Panic of 1797 in many ways, although its severity and global impact most commonly drew comparisons to the Great Depression.

There are those who believe that the global recession of 2007–2010 and the subsequent crisis it created came unexpectedly, while others claim to have seen the warning signs more than a year before it began. Because of the numerous causes of this event, global financial crisis that began in 2007 has generated a great deal of academic and political interest in understanding its nature and how its repetition may be avoided in the future. This paper will cast a light on the roots of the 2007–2010 global financial crisis, its impacts, and the tools employed to bring it to a close.

The Housing Bubble. Similar to the Panic of 1797, the roots of the global financial crisis of 2007–2010 can be found in real estate. After the United States began reemerging from the 2001–2004 recession, housing prices began to show unusual upward mobility. Political leaders and other observers, however, were clouded by the apparent good news surrounding home ownership—more homes purchased meant more jobs and more consumer spending. Then again, the rise in housing prices could not be correlated to any other area of growth. In fact, many economists argued that what was occurring was not a sign of economic growth but a housing bubble (an unexpected and temporary inflation in housing prices) that was doomed to burst and contract. In 2005, that possibility became reality, as a number of key markets saw housing prices decline. Then-chair of the Federal Reserve Bank (the Fed) Alan Greenspan acknowledged that the market, in some areas, was becoming "frothy," but said that a housing bubble was unlikely (Freeman, 2005).

By 2006, Greenspan's comments were largely discredited. In fact, many began to turn on the Fed, suggesting that that institution's recommendation that interest rates stay at record low levels (a policy that began in the late 1990s) started a housing boom. Home purchases were promoted by the government as contributors to individual wealth and retirement plans. The Fed even made mortgage interest rates tax-deductible, another incentive for homeowners to buy homes and make renovations thereto (Kohn & Bryant, 2010). Home ownership increased with the government's message to Americans that the more real estate they owned, the greater their wealth would be.

The Community Reinvestment Act and Subprime Lending. The increased number of home purchases that occurred was also attributable to another trend. Lending institutions had begun to sell subprime mortgages to a growing number of homeowners. Subprime mortgages are housing loans that are offered to people with low incomes and/or poor credit. Subprime mortgages have been in existence since the 1990s, although the government strongly encouraged banks to provide affordable loans to low-income and debt-ridden residents since the 1970s, when the government passed the Community Reinvestment Act (CRA) to prevent discrimination among mortgage programs (Brook, 2008). The CRA gave rise to the government's push for lending institutions to have available mortgages that the poor could afford. Subprime lending was ardently backed by the government, including the mortgage security giants Fannie Mae and Freddie Mac. Still, in light of the fact that subprime lending involves providing individual loans of hundreds of thousands of dollars to people already saddled with debt and/or poor credit, there is an obvious risk attached to the practice. Still, the government, Fannie Mae, and Freddie Mac forged ahead with the subprime lending campaign (Brook, 2008).

Because the government was actively promoting subprime lending (and apparently looking the other way on predatory lending), lending institutions became focused on securing high volumes of such mortgages. Major financial institutions, like AIG and Merrill Lynch, worked diligently to compete for this business by acquiring smaller lenders with reputations for subprime lending (Dickey, 2010). These lenders were paid not based on the quality of the mortgages but by volume, and major institutions took account of this volume and the profits it yielded. Indeed, subprime lending presented great potential returns in the short term.

By 2007, it became clear that the risks associated with subprime mortgages were very real. A stagnant economy meant more people were making less and starting to realize that they were unable to meet their financial commitments. The Fed, which is supposed to protect banks through regulation, went instead with the tide, supporting the subprime industry and the dangers they represented. In fact, the Fed did not require financial institutions to set aside the adequate amount of money to offset potential losses—this regulatory requirement was woefully outdated (Appelbaum & Cho, 2009). Meanwhile, the Fed signed off on acquisitions of subprime lenders made by Citigroup and Wachovia, two major financial institutions with global connections. Banks also sought to offset the risks by selling high-risk loans in pools on the markets. Over time, banks began to realize that the housing market was becoming sour, and their losses were starting to pile up.

Further Insights

The Crisis Goes Global. The overwhelming losses affecting US-based financial institutions sent shockwaves around the world. Financial giant Lehman Brothers went bankrupt in September 2008 and AIG teetered on the brink as well. High-risk mortgages were folded into other pension, mutual, money market, and other funds in order to mitigate those dangers. Investors from all over the world were unwittingly made participants in the subprime industry; when the risks came to fruition, investors worldwide experienced losses. In fact, because few understood that the subprime lending industry was so vast and integrated into the securitized market, some investors actually invested more of their money than they had through leveraging; their faith in the marketplace was based on ignorance of the presence of toxic subprime mortgages.

The growing global crisis was exacerbated by the fact that, in the midst of the collapse of Wall Street's biggest figures, short-term lending and capital was nearly halved. New loans to large borrowers fell by 47 percent in the last quarter of 2008 compared to the previous quarter. Lending actually sloughed by 79 percent compared to the height of the "credit boom," which had peaked in 2007 (Ivashina & Scharfstein, 2010). Banks, particularly those that were dependent on credit rather than deposit accounts, were becoming less likely to lend to expanding businesses. On the global stage, monetary policy was extremely loose. Monetary policy that was used in the United States to boost consumption after the "dot com" bubble burst during the early twenty-first century led to a large number of trade imbalances with emerging market economies such as China (Mohan, 2009). These emerging economies were also threatened by the instability in the United States and Europe, as a large proportion of their income is derived from goods and services provided to Western countries, which now had less money to spend on them.

Lack of Communication. If the United States Federal Reserve did little to curtail the growth of the subprime mortgage issue, the Fed's peers on the international stage did little to halt the crisis as it spread overseas. The International Monetary Fund, the World Trade Organization, and networks of regulatory agencies all fell short on efforts to address the growing crisis. Some argue that the failure of these international organizations and networks (as well as the US financial regulatory system) was not based on an ignorance of the scope of the subprime issue but rather due to a lack of global connectivity between these regulatory bodies (Zaring, 2010). Unlike the markets, these groups were not interconnected prior to the period in which subprime lending developed into a juggernaut. Without the ability to recognize the roots of the growing problem and fashion an adequate response, the regulatory organizations of the global economy could not intervene quickly enough to contain the crisis.

The American financial crisis spread quickly to other international markets. One month after the Lehman Brothers collapse in 2008, the European Central Bank spent approximately €771 billion to provide emergency liquidity to European banks in order to slow the growing crisis. However, fears on the European markets continued to rise—banks began offering much higher interest rates based on distrust in market stability (Teply, Cernohorska & Cernohorska, 2010). The fact that international lenders were pulling back on credit meant that the financial crisis that had begun in the United States was now a global issue—one that threatened the stability of some of the world's most integrated market systems.

Conditions in Europe. The globalization of the financial crisis occurred while the European Union was already in a vulnerable position. Countries such as Greece, Italy, Ireland, and the Baltic states, by joining the European Union and suddenly experiencing the low interest rates that accompanied the Euro, began to consume in large quantity. Spain, for example, built more homes in 2006 than Germany, France, and Great Britain combined. The former Soviet nations in the Baltics saw a 15 percent growth rate—a rate that was built not on economic growth but on credit ("The financial crisis," 2008).

One of the most glaring and potentially devastating situations during the tail end of this crisis was centered in Greece. For years leading up to the crisis, that country had taken advantage of low Euro-based interest rates and engaged in a spending policy that resulted in a condition of severe debt. In 2009, the crisis continued to topple banks from Europe to Asia. Incoming Prime Minister George Papandreou assumed office to discover that the severe debt Greece suffered had been woefully understated, and that it was in fact three times higher than previously thought ("Credit Crisis," 2010). Papandreou announced his commitment to reducing the country's debt—a move that was made to placate the European Union as well as Greek voters. His government pushed for a hard-line austerity plan, slashing public services as well as other large portions of the Greek budget. In return, he sought help from the European Union—a request that the International Monetary Fund and the European Union begrudgingly voted to approve, authorizing €110 billion in aid to that country. Throughout the European Union and the rest of the international community, however, fears remained that, if Greece defaulted on its debt in an already tumultuous global economy, it could have devastating impact on the markets (Parker, 2010). Such a situation would send ripples from Europe around the globe and could return the international economy to a state of recession. Greece defaulted on its debt obligation in the summer of 2015, but the country accepted increased austerity measures in October 2015 in order to receive an additional $2.3 billion in bailout funds in order to pay off its international loans. However, the European Union has taken measures to limit financial contagion if Greece should leave the Eurozone, reducing the potential negative impact of the Greek debt crisis on the global financial system.

Intervention and Avoiding Recurrence. One of the most significant developments fostered by the global financial crisis of 2007–2010 was the reversal of policy regarding government's role in private industry. During the 1990s, the government had stayed largely away from direct involvement on Wall Street. As stated earlier, the Fed (and indeed the entire federal government) did nothing to mitigate subprime lending; in fact, it was actively promoted.

However, when the crisis reached global proportions, the administrations of Republican George W. Bush and Democrat Barack Obama both saw the need to inject an enormous sum of money into the financial industry to prop up flagging financial institutions. The Troubled Asset Relief Program (TARP) of 2008, for example, appropriated $700 billion of taxpayer money to "bail out" those financial institutions that, because of their connections to global markets, were deemed too big to be allowed to fail. While there were previous stimulus efforts in recent decades, TARP and other government-sponsored industry investments had strings attached. These bills came with regulatory changes, business policy requirements, and other rules that dictated how recipients should operate in order to prevent future such crises (Moulton & Wise, 2010).

In 2010, the US Congress passed a series of major reforms to the country's financial system. The bill, called the Dodd-Frank Wall Street Reform and Consumer Protection Act, added several new rules regarding credit approval and lending practices, risk mitigation, and fees. The law also created several new oversight programs, including the introduction of a new bureau within the Federal Reserve charged with consumer financial products, such as mortgages and credit cards (Jackson, 2010). The new law was significant for its major reversal of policy, from a laissez-faire approach to the financial markets to one in which the government more heavily regulated virtually every type of investment and at every level of risk.

The severe contraction that began in 2007 and continued until 2010 had a significant impact worldwide. Though measures such as TARP were able to help financial corporations mitigate the damages caused by the subprime crisis, the federal government's slowness to action, followed by a similar reaction by international regulatory agencies and organizations meant that recovery was a slow process. Some forecast a continued, though shallower, decline in lending ("United States banking sector outlook," 2010). Unemployment rates remained high in the United States and throughout much of the world for years. Although recovery persisted, it was weak, and many feared a "double dip." The Eurozone, particularly, continued to struggle over the four years following the end of the recession, facing persistently high unemployment rates, the threat of deflation, and stagnating economic growth rates. The long-term impact of the crisis of 2007–2010 remains uncertain, as reforms had scarcely been imposed before calls to repeal at least some measures began. The breadth, causes, and responses of the global crisis will be the focus of analysts and arguments for the foreseeable future. However, the financial crisis did underscore the dominance of the financial sector in US politics and has signaled an erosion of US financial and economic power and influence worldwide.

Viewpoints

Will Reform Work?. Although these reforms are significant, there are those who believe that such reforms are likely to fall short unless policymakers target risk on every level—from the risk managers in private businesses to the taxpayers themselves. It has been argued that the policymakers were both active supporters of the creative risk-taking that was associated with subprime lending as well as absorbing losses during crises (Kane, 2010). While the reforms add a layer of regulatory oversight, the government previously had a watchdog in place, the Fed, before the crisis took shape. According to some critics of the measure, the law simply looked to enforce the same faulty system of laws that allowed the crisis to unfold (Bozzo, 2010). Unless all parties, including the federal government and the investors themselves, adopt a more cautious approach regarding risk, reform measures such as these may not be effective enough to prevent further crises.

In the United States and elsewhere, many of the worst economic periods were worsened by the inaction of government leadership. It may be argued that this inaction was largely due to the political unpopularity of government intervening in the free market. This assertion is given validity in particular in light of the most recent economic crisis. After the major recession and economic slowdown of 2001–2004, the government continued its campaign of stressing affordable home ownership, even for those who might not be able to afford such real estate over the long term. The glut of home purchases created a housing bubble that many chose to disregard. It also created toxic subprime mortgages that spread throughout the increasingly global marketplace.

An interesting aspect of the global crisis of 2007–2010 was not necessarily that the government failed to intervene when the crisis first began. In fact, one of the most egregious issues was the fact that there were actually safeguards in place designed to prevent a widespread crisis. As shown here, the Fed had regulations in place designed to mitigate risk and warn lenders against the dangers of subprime lending. Unfortunately, the federal government's endorsement of the subprime industry started a lucrative wave of home purchases that neither the United States or international government watchdogs sought to curtail.

Conclusion

The three-year financial crisis that completed the first decade of the twenty-first century was one of the worst economic periods in modern history. It is notable particularly because it showed the interconnectedness of the global economy. It is likely that, had key financial institutions not received billions of dollars in emergency aid, the crisis would have been far more devastating on the international stage. Nevertheless, there are lessons to be learned based on this crisis—historical concepts that, if not assessed, could force future elements of the global economy to repeat them.

Terms & Concepts

Community Reinvestment Act (CRA): A 1970s law passed to prevent discrimination in mortgage lending for home ownership.

Federal Reserve Bank (Fed): The agency charged with regulating banks and financial institutions in the United States.

Housing Bubble: An uncorrelated increase in the price of residential real estate which becomes unsustainable and can even result in negative equity for the homeowner.

Subprime Mortgage: Housing loan offered to residents with low incomes and/or debt issues.

Troubled Asset Relief Program (TARP): A law passed in 2008 to fund emergency aid for failing financial institutions and other industries as a result of an economic crisis.

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Suggested Reading

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