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The global financial crisis of 2008 was caused by a multitude of factors, most of which originated in the USA particularly within New York's financial sector .
The first problem contributing to the crisis was the housing market bubble and its subsequent crash. In the early 2000’s, house prices had been growing rapidly, peaking in 2006. This growth was fuelled by mortgage lending increases in New York and other leading cities; an increase in loan incentives such as easy initial terms and a long-term trend of rising house prices had encouraged borrowers to assume risky mortgages in the anticipation that they would be able to quickly refinance at easier terms. Due to misaligned incentives, loan underwriting practices focused on originating loans to distribute and not to hold, resulting in a large expansion of credit. This excess availability of mortgage credit shifted housing demand outward by enabling existing and new borrowers to spend more on housing. This subsequently led to a growth in the issuing of subprime mortgages; these are higher interest mortgages offered to borrowers with impaired credit risks. This meant that people could borrow above their limit, with little to no guarantee that they could fulfil these financial obligations. This rise in subprime lending and housing speculation created a house price bubble. This created a false sense of wealth in terms of property levels and what people could afford.
Another important factor in causing the financial crisis was financial deregulation, which allowed the emergence of shadow banking. The shadow banking system refers to financial intermediaries (e.g. hedge funds, mortgage lenders) which participate in creating credit; however, unlike traditional banks, they operate with little to no regulations. The Commodity Futures and Modernisation Act of 2000 left derivatives and OTC markets completely unregulated. This meant that these entities were able to make risky investments that they hid from investors through off-balance sheet derivatives.
Investment banks (shadow banks) looking for a new and safe way to make money noticed the long-term trend of rising house prices and decided to invest in the housing market. They did this by buying mortgages which they then bundled into packages called mortgage-backed-securities (MBS) and sold on to investors. The value of these MBS is derived from the value of their mortgage payments and house prices. Since house prices were soaring, MBS were of high value, thus there was a huge increase in demand from private investors to buy them. This contributed to the growth in subprime mortgage loans as shadow banks wanted to ‘buy’ more mortgages to package into MBS and sell on to investors. Since these investment banks were selling the MBS they lost the incentive to avoid risk and started investing in extremely high-risk mortgages. They packaged these mortgages into collateralized debt obligations (CDOs) which they again sold onto private investors. Such financial innovation in New York enabled institutions and investors around the world to invest in the U.S housing market.
Agencies like Moody’s and Fitch, with head offices in New York, played a crucial role by providing high ratings to securities that turned out to be high risk. They did this because the market provided the wrong incentives; since these agencies were paid by shadow banks there was an incentive to give these CDOs high ratings otherwise shadow banks would switch to another agency due to a positive cross-elasticity of demand. These ratings were influential in the wide distribution and perceived safety of these high-risk assets.
Insurance companies wanted to ‘cash in’ on the housing market as well, consequently leading to them selling credit default swaps (CDS) to investors. CDS are derivatives that pay out if a mortgage borrower defaults.
However, once interest rates began to rise and housing prices started to drop in 2007, many borrowers in the US were unable to refinance. Defaults and foreclosure activity increased dramatically as easy initial terms expired, house prices went into free fall and adjustable rate-mortgage interest rates reset higher. As housing prices fell, global investor demand for mortgage-related securities fell rapidly. This became apparent by July 2007, when investment bank Bear Stearns announced that two of its hedge funds had imploded. These funds had invested in securities that derived their value from mortgages. When the value of these securities dropped, investors demanded that these hedge funds provide additional collateral. Since unregulated banks, such as Bear Stearns, had no loss-absorbing capital or redemption cash, with no access to official liquidity support to prevent fire sales, in order to pay investors back, the hedge funds had to sell their assets at a lower price. Fire sales decreased the value of these assets, forcing other shadow banks holding similar assets to drop their book values to reflect the lower market price. As a result, investors associated with these banks demanded their money back; this created a cascade of selling on these securities, which only further decreased their value as supply of them rapidly increased. Consequently, as housing prices declined, major global financial institutions that had borrowed and invested heavily in MBS reported significant losses. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. When 70% of CDO’s defaulted, investors in CDS demanded their pay out; however since insurance companies had stacked up $60 trillion worth of CDS it was impossible for firms to pay all this out leading to further bankruptcy of financial institutions. Many people view the height of the crisis as 15th September 2008 when the investment bank Lehman Brothers went bankrupt - this was the largest bankruptcy occurring in history at the time, with a loss of $600 billion of assets.
The losses experienced by financial institutions impacted their ability to lend thus slowing economic activity. Inter-bank lending dried-up and loans to non-financial firms were affected. This led to concerns regarding the stability of key financial institutions causing central banks to take action to provide funds to encourage lending while governments bailed out key financial institutions. All of the key investment banks involved were ‘icons of wall street’, headquartered in New York. The operation of the shadow financial system and its impact globally can be evidenced through the example of American International group (AIG). AIG, one of the world’s largest insurance companies, was bailed out in September 2008 by the US government to prevent its imminent bankruptcy which was caused almost single-handedly by AIG Financial Products, a subsidiary section of the firm. AIG FP was a leader in the issuance of CDS, and the sale of CDS as well as CDO’s. Prior to 2007 AIG FP was not only the most profitable part of AIG, but was also referred to as the “golden goose for the entirety of Wall street”, reflecting its key role as the conduit of CDO and CDS production and distribution in Europe and thus New York’s financial sector’s sphere of influence globally.
The slowing of economic activity exerted downward pressure on consumer spending which led to a huge increase in unemployment with two million Americans losing their jobs in the last 4 months of 2008 alone. This is because demand for labour is derived from demand for goods and services and so when consumer spending fell so did demand for labour. As a result economic growth took a downturn leading to the Great Recession of 2008.
Because New York and the companies involved were seen as respected global entities, other countries had imitated this subprime model. Suddenly, what was occurring in New York, became a crisis on a worldwide scale. This is why the shocking collapse of the New York financial sector had a huge impact globally and was the primary cause of the financial crisis of 2007-8.
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