TheFinancialCrisisof2008:YearIn

Review2008
In2008theworldeconomyfaceditsmostdangerouscrisissincetheGreatDepressionofthe1930s.
Thecontagion,whichbeganin2007whenskyhighhomepricesintheUnitedStatesfinallyturned
decisivelydownward,spreadquickly,firsttotheentireU.S.financialsectorandthentofinancial
marketsoverseas.ThecasualtiesintheUnitedStatesincludeda)theentireinvestmentbanking
industry,b)thebiggestinsurancecompany,c)thetwoenterprisescharteredbythegovernmentto
facilitatemortgagelending,d)thelargestmortgagelender,e)thelargestsavingsandloan,andf)two
ofthelargestcommercialbanks.Thecarnagewasnotlimitedtothefinancialsector,however,as
companiesthatnormallyrelyoncreditsufferedheavily.TheAmericanautoindustry,whichpleaded
forafederalbailout,founditselfattheedgeofanabyss.Stillmoreominously,banks,trustingnoone
topaythemback,simplystoppedmakingtheloansthatmostbusinessesneedtoregulatetheircash
flowsandwithoutwhichtheycannotdobusiness.Sharepricesplungedthroughouttheworldthe
DowJonesIndustrialAverageintheU.S.lost33.8%ofitsvaluein2008andbytheendoftheyear,a
deeprecessionhadenvelopedmostoftheglobe.InDecembertheNationalBureauofEconomic
Research,theprivategrouprecognizedastheofficialarbiterofsuchthings,determinedthatarecession
hadbegunintheUnitedStatesinDecember2007,whichmadethisalreadythethirdlongestrecession
intheU.S.sinceWorldWarII.
Eachinitsownway,economiesabroadmarchedtotheAmericandrummer.Bytheendoftheyear,
Germany,Japan,andChinawerelockedinrecession,asweremanysmallercountries.ManyinEurope
paidthepriceforhavingdabbledinAmericanrealestatesecurities.JapanandChinalargelyavoided
thatpitfall,buttheirexportorientedmanufacturerssufferedasrecessionsintheirmajormarketsthe
U.S.andEuropecutdeepintodemandfortheirproducts.Lessdevelopedcountrieslikewiselost
marketsabroad,andtheirforeigninvestment,onwhichtheyhaddependedforgrowthcapital,
withered.Withnoneofthebiggesteconomiesprospering,therewasnoobviousenginetopullthe
worldoutofitsrecession,andbothgovernmentandprivateeconomistspredictedaroughrecovery.

Origins
HowdidacrisisintheAmericanhousingmarketthreatentodragdowntheentireglobaleconomy?It
beganwithmortgagedealerswhoissuedmortgageswithtermsunfavourabletoborrowers,whowere
oftenfamiliesthatdidnotqualifyforordinaryhomeloans.Someofthesesocalledsubprime
mortgagescarriedlowteaserinterestratesintheearlyyearsthatballoonedtodoubledigitratesin
lateryears.Someincludedprepaymentpenaltiesthatmadeitprohibitivelyexpensivetorefinance.
Thesefeatureswereeasytomissforfirsttimehomebuyers,manyofthemunsophisticatedinsuch
matters,whowerebeguiledbytheprospectthat,nomatterwhattheirincomeortheirabilitytomakea
downpayment,theycouldownahome.
Mortgagelendersdidnotmerelyholdtheloans,contenttoreceiveamonthlycheckfromthemortgage
holder.FrequentlytheysoldtheseloanstoabankortoFannieMaeorFreddieMac,twogovernment
charteredinstitutionscreatedtobuyupmortgagesandprovidemortgagelenderswithmoremoneyto
lend.FannieMaeandFreddieMacmightthensellthemortgagestoinvestmentbanksthatwould
bundlethemwithhundredsorthousandsofothersintoamortgagebackedsecuritythatwould
provideanincomestreamcomprisingthesumofallofthemonthlymortgagepayments.Thenthe
securitywouldbeslicedintoperhaps1,000smallerpiecesthatwouldbesoldtoinvestors,often
misidentifiedaslowriskinvestments.
Theinsuranceindustrygotintothegamebytradingincreditdefaultswapsineffect,insurance
policiesstipulatingthat,inreturnforafee,theinsurerswouldassumeanylossescausedbymortgage

holderdefaults.Whatbeganasinsurance,however,turnedquicklyintospeculationasfinancial
institutionsboughtorsoldcreditdefaultswapsonassetsthattheydidnotown.Asearlyas2003,
WarrenBuffett,therenownedAmericaninvestorandCEOofBerkshireHathaway,calledthem
financialweaponsofmassdestruction.About$900billionincreditwasinsuredbythesederivatives
in2001,butthetotalsoaredtoanastounding$62trillionbythebeginningof2008.
Aslongashousingpriceskeptrising,everyoneprofited.Mortgageholderswithinadequatesourcesof
regularincomecouldborrowagainsttheirrisinghomeequity.Theagenciesthatranksecurities
accordingtotheirsafety(whicharepaidbytheissuersofthosesecurities,notbythebuyers)generally
ratedmortgagebackedsecuritiesrelativelysafetheywerenot.Whenthehousingbubbleburst,more
andmoremortgageholdersdefaultedontheirloans.AttheendofSeptember,about3%ofhomeloans
wereintheforeclosureprocess,anincreaseof76%injustayear.Another7%ofhomeownerswitha
mortgagewereatleastonemonthpastdueontheirpayments,upfrom5.6%ayearearlier.By2008the
mildslumpinhousingpricesthathadbegunin2006hadbecomeafreefallinsomeplaces.What
ensuedwasacrisisinconfidence:aclassiccaseofwhathappensinamarketeconomywhenthe
playersfromgiantcompaniestoindividualinvestorsdonottrustoneanotherortheinstitutionsthat
theyhavebuilt.