The global financial crisis of 2008 was the worst economic disaster since the Great Depression. It caused upheaval in financial markets around the world, brought down major banks, and left millions of people without homes, jobs or savings. At its core, the crisis was caused by a toxic combination of deregulation, excessive risk-taking, lax lending standards, and the bursting of a massive housing bubble. But the seeds of the crash were sown over many years through flawed policy decisions and unchecked market excesses.
Decades of Deregulation Set the Stage
The roots of the 2008 crisis can be traced to a decades-long trend of financial deregulation. Starting in the 1980s, a wave of laissez-faire economic policies championed by President Ronald Reagan and Federal Reserve Chairman Alan Greenspan began chipping away at many of the safeguards put in place after the Great Depression.
The Depository Institutions Deregulation and Monetary Control Act of 1980 eliminated interest rate caps and allowed banks to merge. The Garn-St. Germain Depository Institutions Act of 1982 further deregulated savings and loan associations. In 1999, the Gramm-Leach-Bliley Act repealed the Glass-Steagall Act of 1933, tearing down the walls between commercial and investment banking.
These changes gave financial institutions greater leeway to engage in risky activities like proprietary trading with depositors‘ funds. At the same time, the derivatives market was exploding in size. The notional value of derivatives contracts globally skyrocketed from $865 billion in 1987 to over $670 trillion by 2008.
Yet derivatives remained largely unregulated. In 2000, the Commodity Futures Modernization Act all but exempted credit default swaps and other derivatives from oversight. Greenspan and others argued that these complex financial instruments were effectively "regulating themselves" and posed little risk.
The Housing Bubble Inflates
With the doors blown open for risky financial engineering, all that was needed was a spark—and the housing market provided it. In the early 2000s, the U.S. housing market was booming, fueled by historically low interest rates and lax lending standards. Between 1997 and 2006, housing prices in the U.S. soared by 124%.
U.S. Housing Price Index, 1991-2008. Source: S&P Case-Shiller 20-City Composite Home Price Index
Banks began doling out mortgages to nearly anyone who wanted one. Subprime mortgages—loans to borrowers with poor credit—exploded in popularity. In 2003, just 8% of mortgages were subprime; by 2006 they made up over 20% of the market. Lenders offered increasingly exotic loan products like adjustable-rate mortgages (ARMs), interest-only loans, and negative amortization loans.
Government policies also played a role in stoking the housing frenzy. Presidents Bill Clinton and George W. Bush both pushed to increase homeownership rates, including for lower-income Americans. In 1995, the Clinton administration set a target of 67.5% homeownership by 2000, up from 64%. Banks were given incentives and pressures to lend more to underserved communities and borrowers.
The government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which purchase and securitize mortgages, were central to this effort. From 1994 to 2003, Fannie Mae‘s lending to low- and moderate-income borrowers jumped from 34% to 50% of its total purchases. By 2008, Fannie and Freddie owned or guaranteed nearly half of the $12 trillion U.S. mortgage market.
Subprime Lending and Securitization
As housing prices climbed and climb ed with no end in sight, banks began taking more and more risks to cash in. The subprime mortgage market in particular underwent a sea change as lenders abandoned traditional standards.
In 2006, nearly half of all subprime loans were made without full documentation of the borrower‘s income or assets. The median down payment for subprime mortgages hit a low of just 2%. Low- or no-doc "liar loans" became commonplace. Adjustable-rate mortgages with low teaser rates proliferated, saddling borrowers with loans that would become unaffordable when rates reset higher.
| Year | Subprime share of market | Median subprime down payment |
|---|---|---|
| 2000 | 7% | 5% |
| 2003 | 8% | 6% |
| 2006 | 20% | 2% |
The Growth of Risky Subprime Lending. Source: Joint Center for Housing Studies of Harvard University
For banks, the risk was mitigated through securitization. Rather than holding mortgages on their books, lenders would bundle hundreds of loans into mortgage-backed securities (MBS) and sell them off to investors. By 2006, about 80% of subprime mortgages were securitized.
This "originate-to-distribute" model drastically reduced the incentive for banks to properly vet borrowers, as they would not bear the losses of default. As long as housing prices kept rising and borrowers could refinance, it all worked—but it was a house of cards waiting to collapse.
The Rise of Shadow Banking
Alongside traditional banks, a "shadow banking" system arose that connected borrowers and lenders through a complex chain of non-bank financial intermediaries. This included investment banks, hedge funds, money market funds, insurers and others. By 2007, the shadow banking system had $22 trillion in liabilities in the U.S. alone.
A favorite instrument of the shadow banks was collateralized debt obligations (CDOs). CDOs are structured products that pool together MBS and other debts into tranches of varying risk and return. The most senior tranches were rated AAA despite containing risky subprime loans.
Demand for CDOs was voracious due to their juiced returns. Merrill Lynch underwrote $44.5 billion of CDOs in 2006 alone. This created perverse incentives for originators to churn out more and more subprime loans to feed the securitization machine, regardless of loan quality.
Credit default swaps (CDS), a form of credit derivative that functions like insurance on debt, were used to further transfer risk. But unlike insurance, CDS were traded over-the-counter with virtually no regulation. When AIG collapsed in 2008, it had written over $440 billion in CDS—more than the entire GDP of Indonesia.
Warnings Ignored
Even as the housing bubble reached dizzying heights, red flags abounded. Economists like Dean Baker and Robert Shiller warned early on that prices were unsustainable. Investor Warren Buffett called derivatives "financial weapons of mass destruction" back in 2003.
But these warnings fell on deaf ears in a climate of deregulatory zeal. The prevailing wisdom held that financial innovation had conquered risk. "The use of a growing array of derivatives and the related application of more sophisticated approaches to measuring and managing risk are key factors underpinning the enhanced resilience of our largest financial institutions," Greenspan declared in 2005.
Crucially, regulators failed to use the powers they had to rein in excessiv e risk. The SEC relaxed capital requirements on investment banks in 2004, allowing them to ramp up leverage to as high as 40-to-1. The Federal Reserve chose not to impose suitability standards on subprime lenders. Proposals for tighter CDS regulation were shot down.
As late as March 2007, Ben Bernanke, Greenspan‘s successor at the Fed, testified before Congress that "the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."
The Bubble Bursts
Cracks began appearing in 2006 as the housing market cooled and subprime borrowers started to default. By 2008, nearly 10% of all mortgages were delinquent or in foreclosure. With falling home prices, borrowers could no longer refinance and foreclosure rates soared.
U.S. Foreclosure Rates, 2006-2010. Source: Mortgage Bankers Association
As losses piled up, faith in MBS and CDOs collapsed. Banks and investors globally were left holding billions in toxic assets they couldn‘t price. Credit markets froze as institutions hoarded cash and stopped lending to each other, not knowing who might be insolvent.
The failure of Lehman Brothers on September 15, 2008 turned the liquidity crisis into an all-out panic. The Dow plunged 504 points that day, its worst drop since 9/11. In the following weeks, lending seized up and the commercial paper market nearly broke down entirely.
To avert complete meltdown, the government unleashed an unprecedented intervention. The Federal Reserve pumped $1.2 trillion in emergency lending into the system. Congress approved a $700 billion bank bailout through TARP. The Fed lowered interest rates to near-zero and launched quantitative easing to inject liquidity.
But the damage was done. The U.S. entered its worst recession in decades as credit dried up and consumer spending plummeted. Unemployment peaked at 10% in 2009. The housing crash wiped out over $7 trillion in home equity. Globally, the crisis erased more than $30 trillion in market value.
Contagion Goes Global
The carnage quickly spread beyond U.S. borders. Banks and investors worldwide had gorged on U.S. subprime debt in the boom years. When the MBS market implod ed, contagion ripped through the global financial system.
In the U.K., Northern Rock faced a classic bank run as customers lined up to withdraw deposits. The British government was forced to nationalize it along with Bradford & Bingley. Iceland‘s three largest banks collapsed under massive debts amounting to 11 times the country‘s GDP. Ireland‘s banks required a €64 billion bailout.
The crisis exposed deep flaws in Europe‘s financial and regulatory architecture. European megabanks were shown to be overleveraged and undercapitalized. Germany‘s IKB and state banks had over €200 billion in toxic assets. In many European countries, banking assets exceeded GDP many times over.
| Country | Banking assets to GDP |
|---|---|
| Iceland | 880% |
| U.K. | 550% |
| France | 420% |
| Germany | 320% |
| U.S. | 100% |
Banking Assets Relative to GDP, 2007. Source: OECD
The crisis also laid bare imbalances within the Eurozone. Countries like Greece and Portugal, which had borrowed heavily in the boom, found themselves on the brink of insolvency. Austerity measures imposed as a condition of EU bailouts pushed economies deeper into recession, triggering a sovereign debt crisis.
In Asia and emerging markets, the crisis sparked a collapse in exports and foreign investment. China launched a massive $586 billion stimulus to counteract the downturn. But many developing countries lacked the resources to adequately respond. The number of people in poverty globally would increase by over 100 million.
The Fallout
The 2008 financial crisis left deep scars that are still felt today. It exposed glaring shortcomings in the financial system and its oversight. Critics argue that the "too big to fail" banks at the heart of the crash have only gotten bigger since. Unprecedented central bank intervention unleashed a wave of asset inflation and rising debt burdens.
At a societal level, the crisis exacerbated inequality and distrust in institutions. Millions saw their life savings decimated while banks got bailed out. Political polarization intensified in the crisis‘s wake, fueling populist backlash on both the left and right.
Policymakers did enact some reforms in response, but many argue they have not gone far enough. The 2010 Dodd-Frank Act bolstered regulation of systemically important financial institutions and derivatives markets in the U.S. But its most transformative measures, like breaking up the big banks, were watered down or left out.
Internationally, the Basel III accord increased capital requirements for banks, but implementation has been gradual. Efforts to address "too big to fail" through living wills and orderly liquidation rules remain works in progress. Much of the shadow banking system endures outside the regulatory perimeter.
Ultimately, the 2008 financial crisis exposed deep structural flaws in an economic paradigm prioritizing unfettered finance over public interest. Its lessons on the dangers of runaway financial excesses, regulatory capture and moral hazard remain as urgent today as ever. Only by reckoning with its true causes and consequences can we hope to build a financial system that is stable, sustainable and just.
