Lehman Brothers’ famous London headquarters sign is auctioned off at Christie’s in September 2013.

The housing market bubble and the subprime crisis

Even before the financial markets collapsed in late 2008, contagion had begun in the US as early as 2006, perhaps even 2005, notably because of the country’s dysfunctional housing market, and the subprime mortgage crisis that eventually spread to the country’s banks, which had been undervaluing the risk associated with this highly speculative market. The US’s housing market bubble was created by overly easy credit, which allowed home ownership to rise sharply to almost 70% of American housholds, but also caused prices to shoot up: between 1996 and 2006, housing prices actually doubled on average in the US. For years, mortgage dealers had been offering subprime loans (i.e., expensive loans offered to less reliable borrowers, as opposed to the prime lending rates offered to wealthier ones)to middle class and even underprivileged Americans, including the infamous “Ninja loans” (i.e., “No Income No Job” people). Some of these subprime mortgages carried low “teaser” interest rates in the early years but also included unfavourable terms, typically adjustable rates that could balloon to double-digit rates in later years. This was easy to miss for unsophisticated first-time home-buyers, who were beguiled by the promise that, regardless of their income or their ability to make downpayment, they were given the opportunity to own a home.

Meanwhile, mortgage lenders did not merely hold the loans and content themselves with receiving monthly checks from mortgage holders. Frequently they actually sold the loans on to banks or institutions like Fannie Mae (i.e., the Federal National Mortgage Association) or Freddie Mac (Federal Home Loan Mortgage Corporation), two private institutions chartered by Congress to buy up mortgages and help mortgage lenders with more money. Then Fanie and Freddie sold many of the mortgages to investment banks, which, through a form of financial engineering called securitization (i.e., the transfer of risk to others), would bundle – or “pool” – them with hundreds or thousands of others (other mortgages, but also car loans, student loans, credit card debts) into mortgage-backed securities (MBS), asset-backed securities (ABS) and most of all collateralized debt obligations (CDOs), i.e., more and more sophisticated financial products that were sold to investors, often misidentified as low-risk investments. Indeed, all through the period, rating agencies (notably Moody’s, Standard & Poor’s and Fitch) rated such products as very safe, i.e., AAA, like most government bonds (the worst grade being BB, i.e., “junk”), inciting investors to buy billions of them. In fact, most of the products and the players involved were very highly rated (AAA or A2) even until the day they collapsed. (In 2008, when they were accused of being complicit to the investment banks’ lies regarding their junk products or even the financial health of these institutions, these rating agencies defended themselves by saying they were only offering “opinions”, and could not be held accountable if their ratings are been proven wrong… Bear in mind too that these rating agencies are paid by the banks themselves to evaluate their products.)

The insurance industry got into the game by creating derivatives called credit default swaps (CDSs), i.e., insurances stipulating that, in return for a fee, the insurers would assume any losses caused by mortgage-holder defaults. What began as insurance, however, turned quickly into speculation as financial institutions bought or sold credit default swaps on assets that they did not even own. About $900 billion in credit were insured by these derivatives in 2001, and the total soared to an astounding $62 trillion by the beginning of 2008.

Context: Since the 1980s, the progress of information technology and the increasing contribution of mathematicians and physicists to the industry had contributed to an explosion of complex financial engineering, notably the creation of derivatives. By the end of the 1990s, derivatives were already a market of $50 trillion.

As long as housing prices kept rising, everyone profited. But when the housing bubble burst, the market value of homes across America plummeted, more and more mortgage holders found themselves with nothing left, not even the possibility of selling their homes to make payments, and were forced to default on their loans (i.e., to be unable to pay their debts), more and more houses thus having to be foreclosed. In 2007, nearly 1.3 million housing properties were subject to foreclosure; by the end of 2008, the number exceeded 2 million; in 2010, the number of foreclosures had reached 10 million, between 10 to 15% of the total. But then lenders found themselves with repossessed houses and land that were worth infinitely less than they had loaned money for originally, which severely crippled them financially and led many to go bankrupt.

The second stage in the crisis was the collapse in the market value of the subprime mortgage derivatives, entailing colossal losses for all investors. These losses and the knowledge that other institutions were filled to the rim with worthless assets also sparked off a widespread crisis of confidence. Banks simply stopped making the loans that most businesses need to do business; business investment diminished; consumer spending plummeted. Share prices plunged: the Dow Jones industrial average lost 33.8% of its value in 2008. Pension funds suffered severely, as did Americans’ 401(k) plans.

By the end of the year, a deep recession had enveloped most of the globe.

The financial meltdown

The final stage was the financial meltdown that took place in 2008, notably in September, with the bankruptcy of several major financial institutions, including the biggest ones: the two biggest financial conglomerates (Citigroup and JP Morgan), the biggest securities and insurance companies (e.g., AIG), and the “Big Five,” i.e., the five biggest investment banks (Goldman Sachs, Morgan Stanley, Lehman Brothers, Bear Stearns and Merrill Lynch)

Context: Investment banks are part of the ‘shadow banking’ or ‘market-based finance’ system, which means they are entities and activities structured outside the regular banking system that perform bank-like activities. That system  grew rapidly in the years leading up to the 2008 crisis, and was not subject to the same level of oversight as the regular banking system; in the case of the US, in fact, very little oversight at all. In 2007, the Americans’ share of the investment banking industry was 46% (against 39% for their European rivals); in 2018, it was 52% versus 26%…

Banks in the US and around the world were extremely vulnerable at this stage. Attempting to maximize short-term profits, they had been allowing their leverage to run out of control (i.e. the ratio between the money a bank borrows and its own money) – some of them actually reaching an outlandish level of 30:1 – all the while letting their liquid assets and equity fall to historic lows. Typically, the Royal Bank of Scotland (RBS) and Citigroup, respectively the biggest banks in Britain and America at the time (the RBS was actually the biggest in the whole world), had leverage ratios of around 50 when the crisis hit, meaning that they could absorb only $2 in losses on each $100 of assets.

The first major institution to go under was Countrywide Financial Corp., the largest American mortgage lender. It was bought up by Bank of America as early as January 2008. The next victim, in March, was the investment bank Bear Stearns, which had a thick portfolio of mortgage-based securities, and had to be rescued from bankruptcy by JP Morgan Chase for about $1.2 billion (i.e., just $2 a share), while the Federal Reserve agreed to absorb $29 billion of Bear Stearn’s declining assets.

This first involvement in a bailout on the part of the Fed left no doubt that the situation had become serious. This was confirmed by the rescue of Fannie Mae and Freddie Mac in September. By that time, the twomortgage agencies held around 80% of American mortgages. With the rush of defaults of subprime mortgages, Fannie and Freddie suffered badly, their shares falling by 90% in a year. Their collapse would almost certainly have led to financial chaos, not just in US but in the whole world, since many foreign banks, including central banks, had investments in Fannie and Freddie. On September 7, the Treasury Department thus announced a conservatorship (i.e., a government takeover, a de facto nationalization) of both,replaced their CEOs, and promised each up to $100 billion in capital to balance their books. As a whole the bailout eventually cost American taxpayers €187 billion. This bailout became a textbook case of “too big to fail” policies.

Context: ‘Too big to fail’ is a catchphrase referring to a policy according to which some firms, notably banks, are literally so big that their bankruptcy would be disastrous to the whole economic system and that they therefore must be supported by public and/or national institutions when they face potential failure. The expression was popularized in the US in 1984 when Continental Illinois – the seventh largest American bank by deposits – faced bankruptcy (notably because of hazardous speculation on oil and gas) and threatened the country with a bank run, and had to be bailed out by the US government, the Fed and the FDIC (Federal Deposit Insurance Corporation). Most opponents of « too big to fail » argue that large firms should simply be left to fail if their risk management is not effective. Former Federal Reserve Chairman Alan Greenspan thus insisted that risk is part and parcel of financial activities and that no institution should be artificially protected from it by sheer virtue of its size: “If they’re too big to fail, they’re too big”. Mervyn King, the governor of the Bank of England from 2003 to 2013, had the exact same position: “If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big. It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure.” Indeed, the problems entailed by this policy are that the knowledge that big institutions will always benefit from the government’s safety net creates unfair competition for smaller ones, creates a mentality of irresponsibility in big firms, that it encourages them to actually bet against their own interest, that it is tantamount to “too big to jail,” i.e., that it actually fosters a culture of judicial impunity in large financial institutions. On March 6, 2013, US Attorney General Eric Holder would himself admit that the size of large financial institutions made it difficult for the Justice Department to bring criminal charges when they were suspected of crimes, because such charges could threaten the existence of a bank and, by a ripple effect, the national or global economy.

The demise of Fannie and Freddie was just the beginning. In September, a series of other financial institutions collapsed, were forced into mergers or were bailed out by the government. (Fed Chairman Ben Bernanke stated that 12 of the 13 largest U.S. financial institutions were at risk of failure during the crisis).

On September 14, Merrill Lynch, a major investment bank whose “bullish on America” slogan had made it the popular symbol of Wall Street, and whose shares had collapsed, had to sell itself to Bank of America for $50 billion.

Conversely, with some $619 billion in debt (against just $639 billion in assets), another major investment bank, Lehman Brothers could not find a buyer, and the administration this time refused to bail it out. (Actually, the English bank Barclay’s made an offer, but British regulators demanded guarantees from the US administration which it refused to give.) On Monday 15 September (ak.a. Meltdown Monday), Lehman Brothers, the iconic 158 year old Wall Street firm and 4^th biggest American investment bank, with over 25,000 employees around the world, filed for bankruptcy – triggering off losses close to $10 trillion on the global markets in one month.

Context: Wall Street is a street in the heart of the Financial District of Lower Manhattan, whose name is commonly used as a metonym of the US’s financial industry. The place abounds with landmark financial buildings, notably high-rises dating back to the Gilded Age, including the headquarters of major banks, and insurance companies, as well as the country’s major stock exchanges, including the two biggest in the world by market capitalization, the New York Stock Exchange and NASDAQ (the world’s largest electronic stock market, created in 1971). The term can also be used as a metaphor for the culture and interests of financial capitalism and big business as opposed to those of small business and the middle class (hence the opposition between Wall Street and Main Street)

Many critics argue that letting Lehman Brothers go bankrupt was a huge error on the part of the administration and the Fed, emphasizing that it fuelled panic in markets and that, ironically, it forced the government to intervene more, not less, to rescue scores of other companies.

Next, however, came the downfall of American International Group (AIG), the country’s biggest insurer with assets of $1 trillion, which had faced huge losses on credit default swaps (the London office of the bank alone was estimated to have issue $500 billion worth of them). On September 17, the Fed provided it an $85 billion loan, though at a high “punitive” interest rate. When that amount proved insufficient, the Treasury came through with $38 billion more. In return, the government received a 79.9% equity interest in AIG, a de facto nationalization. AIG was also forced to pay back to investment banks all of the money it owed them for the CDSs, which effectively bailed out banks like Goldman Sachs, costing the taxpayer an estimated $150 billion as a whole. AIG was also prevented by the deal from suing Goldman Sachs and other investment banks for fraud.

On September 25, climaxing a frenetic month, federal regulators seized Seattle-based Washington Mutual (WaMu), the country’s largest commercial bank with more than €300 billion in assets, and brokered its sale to JPMorgan Chase for $1.9 billion. This made WaMu the largest commercial bank to fail in American history, while JP Morgan Chase became America’s largest deposit-taker.

Other large banks foundered. In October, Wachovia Corp, a giant North Carolina-based bank crippled with debt was bought up by California-based Wells Fargo. In November the Treasury shored up Citigroup by guaranteeing $250 billion of its risky assets and pumping $20 billion into the bank.

As a whole, the stock market, measured by the Dow Jones Industrial Average, fell from its October 9, 2007 pre-crisis peak of 14,164.53 to 6,594.44 on March 5, 2009.

The Great Recession

The carnage was not limited to the financial sector either, as all companies relying on credit suffered heavily. The American auto industry found itself at the edge of an abyss and had to plead for a federal bailout. The Senate first turned down $14 billion in emergency loans, but President Bush decided to draw $17 billion in loans from the $700 billion financial sector bailout fund, just enough to keep General Motors and Chrysler afloat until the Obama administration took over in early 2009: eventually the complete bailout reached $80 billion, though most of the money was recovered by 2014.

The US lost 3.6 million jobs in 2008, the worst year since 1933, and then 600,000 more in January 2009 alone, the worst single month since 1974. In February 2009, there were 11.6m people unemployed, plus an additional 6m looking for a job but not counted in official data, the unemployment rate thus shooting up to 10% from its recent low of 4.4% in March 2007. Poverty soared. The budget deficit reached 9.8% GDP in 2009. The national debt reached $10 trillion as early as September 2008: by December 2016, it had reached $20trn.