Chapter 12: The Financial Crisis of 2007-2008
A "financial crisis" is said to occur when one or more financial markets ceases functioning outside of normal parameters - it may be non-functional or merely erratic or inefficient. It is said to be "systemic" if it is more widespread than a single firm or sector - generally resulting in a prolonged recession or depression in the broader economy.
(EN: The definition of crisis is very subjective, as it is based on opinion and theory of what the market ought to be doing rather than what it is doing. If no-one is able to obtain capital through the market, it's clearly dysfunctional and critical. But there are those who quickly declare a crisis when interest rates or the amount of capital available are not to their liking. It's a good practice to be critical of anyone who cries "crisis.")
Asset Bubbles
One kind of financial crisis is the asset bubble, which is the rapid increase in the value of some assets that creates a temporary panic (scarcity drives the prices high, profiting speculators) and then a sudden collapse when the panic passes and assets return to reasonable levels (anyone holding those assets and hoping to resell them at a higher price is disappointed, and possibly bankrupted).
Asset bubbles are often attributable to low interest rates, which provides capital at a very low cost, enabling speculators to invest heavily in a given asset. This heavy investing creates a spike in demand, which causes prices to rise dramatically, but the lenders of capital do not collect their share of the profits because interest rates are low. Speculators continue to borrow and invest because they believe the "bubble" will be sustained until they cash out - and they have committed to loans that they must repay even if their investment fails.
Recent financial crises such as the dot-com and real estate booms are the result of asset bubbles, but there have been bubbles throughout history on various commodities: tobacco, oil, cotton, railroads, and tulips have all periods of manic growth.
Financial Panics
Another kind of financial crisis is the panic, in which investors believe that assets will plummet in value, motivating investors to be rid of them. When the number of sellers increases, supply to the market increases, and price falls accordingly, making the panic a self-fulfilling prophecy.
The bank panics that occurred until the establishment of the FDIC were caused by the belief that bank deposits would plummet in value (depositors would not get their cash back), causing depositors to make a run to the bank to withdraw their cash, causing banks to literally run out of money. Fear that consumers in large numbers will default on loan payments likewise causes a panic that motivates lenders to demand early repayment (when they are contractually able to do so) or to sell off their loans at steep discounts.
As with bubbles, panics will eventually end and the asset values will return to a normal level, but nobody knows exactly when, so some individuals are left holding the bag. Generally, those who were in a rush to dispose of their assets are rueful when the assets return to their normal level and they realize that their loss was unnecessary. There are also instances where a panicked seller was leveraged and is attempting to cut his losses, but his loans exceed the proceeds he received from selling his assets and he finds himself strapped.
Lender of Last Resort
When there is a financial crisis, the net result is the unavailability of assets of a certain kind: investors may not have any opportunity to purchase a given kind of asset, or borrowers may not have any opportunity to borrow. The latter is seen as the greater problem, so governments often set up an organization that will act as the "lender of last resort" that has the ability to generate assets from nothing (except future tax payments).
For example, the Federal Deposit Insurance Corporation (FDIC) will provide money to depositors when their bank is no longer able to return deposits; or the Federal Reserve can be authorized to release more money when it becomes scarce. Most governments have "central banks" that serve the same function, though the precise legal mechanism by which they do so varies.
In general, the central banks attempt to stabilize the money supply, distributing more money to the market when it is in short supply, distributing less (or buying back bonds) to tighten the supply when money appears to be depreciating rapidly. The goal is to create just enough money so that the financial system functions, but no so much that money itself becomes devalued.
Bailouts
The lender of last resort is meant to prevent a crisis from occurring, whereas bailouts are instituted after a crisis has occurred to restore the losses to certain parties, which is done with taxpayer money. Bailout funds can be directly granted as a no-strings-attached gift, but are more often invested as equity (the government owns shares of the organization that was bailed out) or as low-interest loans that the government realizes may never be repaid.
Bailouts are politically controversial because they appear to be unfair (given to some but not others), that they reward financial mismanagement, or that they encourage moral hazard (a firm that expects a bailout will not solve its own problems). They are given on the belief that if the recipient were to fail entirely and cease to do business, it would do significant and lasting damage to the economy in general.
In most instances, bailout money is given to companies that provide capital to the market rather than to individual investors who have lost money, who in many cases are held accountable for the debts they accrued during the period of market instability.
The Crisis of 2007-2008
The recent global crisis began as a nonsystemic crisis (that affected only lenders of subprime mortgages) that spread and escalated rapidly into one of the greatest global crises since the Great Depression.
The foundation of this crisis was a government initiative to make mortgages available to any lender, regardless of their ability to repay, then encouraged finance companies to buy these risky mortgages from banks, then gave investment bankers the ability to securitize these mortgages into bonds that disguised their degree of risk. Ultimately, these investors were left holding the bag when it was "discovered" that borrowers could not repay.
In the consumer real estate market, the availability of cheap credit caused a shortage of housing for sale, which created a housing asset bubble with prices rising rapidly. Speculators purchased houses (often multiple ones) entirely on credit that they could not repay (it was assumed they could "flip" houses quickly, even before the first loan payment was due, and collect the profit).
In the consumer lending market, mortgages became much easier to obtain: the mortgage lenders quickly sold off the loans so the risk was not carried on their own balance sheet, then holding companies bought mortgages and securitized them - turned them into a variety of investment vehicles (MBS for mortgage-backed security, CMO as a consumer mortgage obligation, etc.) that would shift the risk to investors, meanwhile representing the bonds as being low-risk securities (backed by some questionable practices by rating agencies). An increasing number of firms popped up that specialized in various organizations to support this industry. These shady practices were allowed, facilitated, and encouraged by government regulators in the name of affordable housing for all.
This all came unraveled when housing prices peaked and borrowers were no longer able to flip houses to gain the profit they needed to pay their loans. Defaults mounted, subprime mortgage lenders collapsed, the debt-backed securities became worthless, and brokerages who had been involved in the real estate swindle teetered on the edge of bankruptcy.
The clean-up was messy: the number of real-estate foreclosures glutted the market with available properties and the screening process for new borrowers swung to the opposite extreme such that few could afford to buy houses, ordinary people were obligated to mortgage loans that were much greater than the value of their property, etc.
The federal reserve stepped in as "lender of last resort" to cover deposits in institutions that were bankrupted, there were widespread buyouts of many banking and financial services firms considered "too big to fail," a few firms were taken over by the government, and a few others were simply allowed to fail.
There's some talk of lessons learned: that investors should be educated about bubbles, banks should hold more of the loans that they write, and the money supply in general should be more closely regulated. No-where is there a note to government to avoid using cheap credit to fuel economic growth, which was the root cause of this crisis as well as the Great Depression.