Describe the historical background to the 2007-2009 financial crisis and summarize its major events.
The idea
The crisis grew out of a US housing and mortgage boom that peaked around 2006. Its first visible signs came in 2007. Subprime defaults rose and two Bear Stearns hedge funds collapsed. On 9 August 2007 BNP Paribas suspended redemptions in three funds because it could not value their US mortgage assets, which froze interbank lending. Northern Rock suffered a retail run in September 2007. Bear Stearns was sold to JPMorgan Chase in March 2008 with Federal Reserve support. In September 2008 Fannie Mae and Freddie Mac went into conservatorship, Lehman Brothers filed for bankruptcy on 15 September, and AIG and the Reserve Primary money fund were hit the next day. TARP, a USD 700 billion rescue authorisation, followed in October. Remember that Lehman's failure turned a credit and liquidity squeeze into a global systemic crisis.
A practice question
Which event in August 2007 is widely seen as the moment when subprime losses turned into a broad liquidity freeze in interbank and funding markets?
- Lehman Brothers filed for bankruptcy protectionWhy not: Lehman failed in September 2008, a full year later, and marked the second phase of the crisis.
- BNP Paribas suspended redemptions in three mortgage-exposed funds - correct
- The US Treasury received authority for a USD 700 billion rescue programmeWhy not: TARP was authorised in October 2008, after the freeze had been under way for more than a year.
- The Federal Reserve cut its target range to 0 to 0.25 percentWhy not: That cut came in December 2008, long after the August 2007 freeze.
On 9 August 2007 BNP Paribas said it could not value assets in three funds and suspended redemptions. Interbank lending seized up that day and central banks began injecting liquidity, so this is the usual start of the acute phase.
A harder one
The Federal Reserve helped arrange the rescue of Bear Stearns in March 2008. Which description of that rescue is correct?
- The US Treasury injected equity into Bear Stearns under TARP and kept it as a public companyWhy not: TARP did not exist until October 2008, and Bear Stearns was sold, not recapitalised.
- Bear Stearns was placed in FDIC receivership and its deposits were transferred to another bankWhy not: Bear Stearns was an investment bank without insured deposits, so the FDIC resolution process did not apply.
- Bear Stearns was sold to JPMorgan Chase, with the Fed financing a portfolio of Bear Stearns assets - correct
- Bank of America bought Bear Stearns, after the Fed lent it funds against Bear Stearns's trading bookWhy not: Bank of America bought Merrill Lynch in September 2008; the buyer of Bear Stearns was JPMorgan Chase.
JPMorgan Chase bought Bear Stearns at a very low price and the Fed lent against a pool of Bear Stearns assets held in a special vehicle. Lehman received no comparable rescue six months later.
The hardest tier
AIG was rescued by the Federal Reserve on 16 September 2008, the day after Lehman failed. Which explanation of why AIG needed the rescue is most accurate?
- Its financial products unit had sold protection on super-senior CDO tranches and could not meet the resulting collateral calls - correct
- Its life insurance policyholders surrendered en masse, draining liquidity from the group's insurance subsidiariesWhy not: The strain came from derivatives collateral calls at its financial products unit, not from policy surrenders.
- It was Lehman's main prime broker, so Lehman's bankruptcy left AIG with unrecoverable client balancesWhy not: AIG was not Lehman's prime broker; its problem was credit protection written on mortgage-linked securities.
- It held large equity tranches of ABS CDOs funded in the repo market, and haircuts on those tranches jumpedWhy not: AIG's exposure was through credit default swaps it had sold, not through repo-financed equity tranches.
AIG Financial Products sold protection on super-senior tranches of multi-sector CDOs. Falling prices and its own downgrade created large collateral demands, and the Fed lent to prevent a disorderly failure of a counterparty to many banks.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Anatomy of the Great Financial Crisis of 2007-2009
- Describe how the crisis built up and which factors were important in that build-up.
- Describe how collateralized debt obligations (CDOs) and subprime mortgages helped bring the crisis about.
- Compare how rating agencies, mortgage brokers and lenders, financial intermediaries and banks each figured in the crisis.
- Explain how shifts in short-term wholesale funding markets fed the crisis, systemic risk effects included.
- Summarize how central banks reacted to the crisis.