Things to Remember About the 2008 Financial Crisis: Major Failures and Key Lessons

By Arun Dahal Khatri

The 2008 financial crisis, often called the Great Recession, is one of the notable economic downturns since the Great Depression of the 1930s. It was precipated by the collapse of the U.S. housing market and the subsequent failure of major financial institutions. This crisis exposed the weaknesses in the financial sector and revealed systemic problems in regulation and monetary policy. To prevent a recurrence of such an event, it is significantly important to understand the major failures that led to the crisis and how they shaped the U.S. and global economies. More importantly, the Federal Reserve's (Fed) response and its chairman's role during the crisis were markable in shaping the recovery and reforming financial system and the regulation.

The Housing Market Boom and Bust

The crisis followed an extended period of growth in U.S. housing construction, fluctuation of housing prices, and mortgage lending, which began in the 1990s and continued into the early 2000s. Between 1998 and 2006, average home prices more than doubled, marking the sharpest increase in U.S. history. Homeownership rates rose from 64% in 1994 to 69% in 2005, and housing-related jobs accounted for roughly 40% of net private sector job creation between 2001 and 2005 (Bernanke, 2010). However, this growth was unsustainable and was not ment for long period. The expansion in the housing market was accompanied by a significant increase in home mortgage borrowing, with mortgage debt rising from 61% of GDP in 1998 to 97% in 2006 (Taylor, 2007). Subprime lending practices, where high-risk borrowers were given mortgages, grew dramatically during this period. Mortgage-backed securities (MBS) and other complex financial products allowed lenders to bundle and sell these high-risk mortgages, spreading the risk across the financial system(MBS is one of the most important term throught the 2008 financial crisis ). When home prices touched the top point in 2006 and started to decline, many homeowners, especially those with subprime mortgages, defaulted on their loans, triggering a ripple effect throughout the financial sector.

The decline in home prices, which began in 2006, was one of the primary causes of the financial crisis. The U.S. housing market saw home prices started to decline by more than 20% between the first quarter of 2007 and the second quarter of 2011 (Federal Housing Finance Agency, 2012). This price collapse led to mortgage defaults and foreclosures, creating massive losses for investors in mortgage-backed securities. The overexposure of financial institutions to these securities led to the downfall of some of the largest firms on Wall Street.

Key Events Leading to the Crisis

A series of critical events between 2007 and 2008 exacerbated the financial crisis. The first signs of trouble appeared in 2007 when the Federal Reserve observed financial market strains due to rising mortgage-related asset losses. In March 2008, Bear Stearns, a major investment bank, got collapsed and was acquired by JPMorgan Chase with assistance from the Federal Reserve (Covitz, Liang, & Suarez, 2009). The acquisition was a harbinger of the severe financial instability unfolding in the coming months. The situationgot worsed in September 2008 when Lehman Brothers, one of the largest investment banks and the leading financial instuation in the world, filed for bankruptcy. This event sent shockwaves through the global financial system, leading to a widespread panic. Lehman’s failure demonstrated and heighlighted how deeply interconnected global financial institutions had become, and its collapse was a tipping point in the crisis. The day after Lehman Brothers filed for bankruptcy, the Federal Reserve intervened to prevent the collapse of AIG, a giant insurance company, by providing a substantial bailout. Citigroup and Bank of America also sought support from the Federal Reserve, the Treasury, and the Federal Deposit Insurance Corporation (FDIC).

The Federal Reserve's Role and Key Decisions

During the financial crisis, the Federal Reserve took major  steps to stabilize the financial system and limit the economic damage. Under the leadership of Chairman Ben Bernanke, the Fed acted as a lender of last resort, providing liquidity to financial institutions and markets under extreme stress. One of the Fed’s earliest interventions was lending programs to support financial institutions. The Fed introduced a credit facility for primary dealers serving as counterparties for the Fed’s open market operations. It also created new programs to provide liquidity to the money, mutual funds, and commercial paper markets, which faced significant pressures (Bernanke, 2012).

In October 2008, the Federal Reserve gained the authority to pay interest on excess reserves held by banks. This policy encouraged banks to hold reserves rather than lend them out, which helped mitigate the potential inflationary effects of the Fed’s expanded lending operations (Ennis & Wolman, 2010). Additionally, the Fed introduced the Term Asset-Backed Securities Loan Facility (TALF) to ease credit conditions for households and businesses by extending credit to holders of high-quality asset-backed securities. Beyond these short-term interventions, the Federal Reserve also took longer-term actions to support the economy’srecovery. In November 2008, the Fed started its first round of quantitative easing (QE), purchasing mortgage-backed and longer-term Treasury securities to put downward pressure on long-term interest rates (Bernanke, 2012). These asset purchases were designed to support broader financial conditions and stimulate economic activity, especially in the housing market where the crisis hit a lot during that major crisis period.

Regulatory Failures and the Dodd-Frank Act

The 2008 financial crisis revealed significant regulatory gaps that made the financial system excessively risky. One of the primary failures was the lack of oversight of the mortgage industry and the widespread issuance of subprime mortgages. Many high-risk mortgages were bundled into mortgage-backed securities and sold to investors worldwide, creating systemic vulnerabilities( One of the prime cause to the downfall of Lehman's Brothers) . As a result, when the housing market collapsed, the losses spread throughout the global financial system. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was introduced in response to these failures. One of its most important provisions was the creation of the Financial Stability Oversight Council, which was tasked with identifying and mitigating risks to the financial system. The act also introduced new regulations for large financial institutions, including systemically important financial institutions (SIFIs), which were subjected to greater oversight by the Federal Reserve (Bank for International Settlements, 2011a).

The Dodd-Frank Act also established the Orderly Liquidation Authority (OLA), which allows the FDIC to wind down failing financial institutions in an orderly manner. This provision was intended to prevent future government bailouts of large financial institutions and ensure that one firm's failure would not pose a systemic risk to the entire financial system (Bank for International Settlements, 2011b).

Lessons from the Crisis

The 2008 financial crisis highlighted several vital lessons that policymakers and regulators must remember to prevent a similar event. First, it demonstrated the dangers of unchecked growth in financial innovation, particularly in the mortgage and securities markets. The proliferation of subprime mortgages and bundling of these risky loans into complex financial products created systemic vulnerabilities that regulators or market participants did not understand well. Second, the crisis underscored the importance of regulatory oversight and coordination. The lack of oversight in the mortgage industry and the failures of credit rating agencies and banks' widespread use of off-balance-sheet vehicles contributed to the crisis. Going forward, it is essential that regulators closely monitor financial innovations and the interconnectedness of financial institutions.

Finally, the crisis showed that central banks must be prepared to act swiftly and decisively during financial stress. The Federal Reserve’s actions, particularly its willingness to provide liquidity to struggling financial institutions and its use of quantitative easing, were crucial in stabilizing the financial system and supporting the recovery.

Conclusion

The 2008 financial crisis was devastating and exposed major flaws in the global financial system. While the U.S. economy has since recovered, the crisis is a stark reminder of the importance of sound financial regulation, prudent lending practices, and coordinated monetary policy. The Federal Reserve, under Chairman Ben Bernanke, played a pivotal role in managing the crisis and guiding the recovery. The reforms introduced in the wake of the crisis, particularly the Dodd-Frank Act, were designed to address the systemic risks that contributed to the collapse and to ensure that future financial crises are less likely to occur.

References

Bank for International Settlements. (2011a). Basel III: A global regulatory framework for more resilient banks and banking system. Revised June 2011.

Bank for International Settlements. (2011b). Global systemically important banks: Assessment methodology and the additional loss absorbency requirement. July 2011.

Bernanke, B. (2005). The Global Saving Glut and the U.S. Current Account Deficit. Speech given at the Sandridge Lecture, Virginia Association of Economists, Richmond, Va.

Bernanke, B. (2010). Monetary Policy and the Housing Bubble. Speech given at the American Economic Association Annual Meeting, Atlanta, Ga.

Bernanke, B. (2012). Monetary Policy Since the Onset of the Crisis. Speech given at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyo.

Covitz, D., Liang, N., & Suarez, G. (2009). The Evolution of a Financial Crisis: Collapse of the Asset-Backed Commercial Paper Market. Journal of Finance, 68(3), 815-848.

Ennis, H., & Wolman, A. (2010). Excess Reserves and the New Challenges for Monetary Policy. Federal Reserve Bank of Richmond Economic Brief, no. 10-03.

Taylor, J. (2007). Housing and Monetary Policy