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History of the Global Financial Crisis

In this video, Professor Peter Knight and Dr Paul Crosthwaite discuss the origins of the global financial crisis.
PAUL CROSTHWAITE: Hello, everyone. Peter and I are here in Edinburgh at the Library of Mistakes. And it feels like a very fitting place to be talking about a key topic on our course, which is the history of the global financial crisis. And together, we want to really dig down into that topic and try to think about exactly what the global financial crisis was, why it was so significant, and indeed why it remains significant and influential and has strong after effects even today. So, Peter, let’s dive straight in with the key question. What exactly was the global financial crisis?
PETER KNIGHT: So the first rumblings were felt in 2007. But it really hit home in 2008. And it begins with the story of a bubble in house prices. But it’s not just a story of a few bad loans. It creates a recession, a worldwide recession. It creates political crisis in a number of countries, like Ireland and Greece. And its effects are still being felt today around the world.
PAUL CROSTHWAITE: And can you explain a bit about what the processes were that underlay this crisis? Where did it come from? What was the back story?
PETER KNIGHT: So I think it really begins in the 1970s with a policy of the American government to spread home ownership to as wide a range of people as possible. And that includes people who are less able to pay their mortgages, people who are less affluent. And this seems an honourable, noble, progressive political aim. But inevitably, some of those mortgages are going to go bad. What happens is that in the 1990s, some banks begin to work out a way of making money from these subprime mortgages. And the way they do that is to bundle together a number of the mortgages and create a securitized asset.
And they can then sell off that asset to other banks, who can then sell it on to others. And that is the real game changer. And the way that it works is, traditionally, a mortgage, you pay back over 25 years. And the payments trickle into the bank slowly over that time. And the bank can only realise the profit on that loan at the end of the 25 years. But by bundling up these mortgages and selling the securitized asset, the bank can register a profit straight away. And it’s some of these new financial products, so-called collateralized debt obligations, or CDOs, that enabled this process.
PAUL CROSTHWAITE: And things didn’t stop there. Did they? These CDOs that you’re talking about could then become CDOs squared, CDOs cubed even, whereby these bundled mortgages could themselves be securitized, could themselves be bundled into assets, which then became tradeable as well. So there is a way in which this whole process is feeding upon itself after a certain point. And that there’s a house of cards being constructed with perhaps inevitable results, which I think we want want to come onto in a moment. We know by now that this whole process ended up turning out rather disastrously.
However, there must have been a set of assumptions or rationale that led people in mortgage lenders, banks, or the financial institutions to believe that this was a system that was actually going to improve things, make things safer, more efficient. So what were these assumptions? What were the underlying ideas that led this whole system to be constructed?
PETER KNIGHT: I think we can identify three assumptions. The first was the idea that although individual mortgages might go bad, if you bundled them together, there would be little chance of them all going bad at the same time. The second assumption was that house prices in the US had never fallen simultaneously right across the country at the same time. The real estate market in the US is very complicated, very varied because the country is so big. And so there was little chance, banks assumed, that house prices could fall nationally at the same time. That seemed a fairly sensible assumption.
And then the third assumption was that if you bundled together these mortgages and then sold off individual slices of those mortgages, you could create very precise risk appetites for the institutional investors who were buying them. And once again, that seemed a fairly sensible and actually quite clever way of dealing with these otherwise subprime mortgages.
PAUL CROSTHWAITE: Can you begin to explain to us how it all fell apart? Why this system didn’t work in the way that it appeared that it should?
PETER KNIGHT: We need to remember that at the heart of this system was the magic, the alchemy of turning a bunch of suspect, subprime mortgages into a supposedly AAA rated, highly valuable asset. That’s the mystery at the heart of it. And what lays behind that is the idea that if house prices would never fall at the same time nationally in the US, there was going to be no problem with these mortgages. But if that was wrong, then these bundles of risky mortgages would begin to unravel. The second problem is that there was an incentive for banks to create more and more of these bundles of subprime mortgages.
The more they created, the more CDOs and CDOs squared that they could sell. So they had to create a conveyor belt. And that meant that they began to start to make loans quite recklessly. They started their own mortgage brokerages in order to generate as many of these subprime loans as they could. And in effect, what you got is a game of financial hot potato. As long as someone else is left burning their fingers, it doesn’t matter to you. You can register the profit. And you can generate this conveyor belt of ever quickening and ever increasing profits.
PAUL CROSTHWAITE: So you were talking, Peter, about the unlucky individuals and institutions in this process who were left holding the hot potato, getting their hands burnt at the end of these series of trades. And these were often somewhat surprising or unlikely organisations. You would have local governments in Norway, pension funds in Argentina, organisations who wouldn’t necessarily have their fingers to the pulse about exactly how reliable, risky, dangerous, or secure these assets actually were, which was an interesting and important facet of this whole process.
PETER KNIGHT: Yeah, it seems like they would have little way of knowing in detail all of the constituent parts of the things they were buying, which raises the question, well, why did they think these things were safe?
PAUL CROSTHWAITE: Yeah, I mean, I think that’s exactly the key question. And I think the simple answer to that is that they were told by seemingly very reliable sources that they were safe, and that they were a sound investment. The way this worked was that once banks had created these assets, they would pass them to ratings agencies, organisations like Moody’s, Standard and Poor, who would then assess this complex, bundled, cluster of mortgages and determine its level of reliability. So you would have a range of ratings. And very often, the rating that would come out, surprise, surprise, would be AAA, the most secure, the most secure rating.
PETER KNIGHT: But why were the ratings agencies giving those AAA scores?
PAUL CROSTHWAITE: Well, there was a real incentive for them to do so. And there was really a misaligned incentive. The incentive of a ratings agency should be to give as objective a rating as possible. However, they equally, and perhaps more importantly, had the incentive that if they continued to give high ratings to the assets that were being passed to them by banks, then they would get more and more business.
PETER KNIGHT: The lack of regulatory oversight, the fact that these incentives were skewed. And yet, no one was challenging the ratings that were being produced, and that is ultimately one of the larger stories about how far the world of finance should be regulated by the state.
PAUL CROSTHWAITE: So the whole question of governmental regulation was obviously really key in the run up to the crisis. And one of the ironies, perhaps, of the crisis itself is that when it hit, there was a movement from light touch, remote, hands off lack of governmental regulation to the state, the government having to step in a really forceful and active way to try to prop up the system that it could no longer support itself. So in the conversation that Peter and I have just been having, we’ve been trying to trace some of the origins, some of the back story of the global financial crisis.
And in the accompanying article, you can read more about how things began to become disentangled once the crisis hit in 2007 to 2008.

In the next three steps, we will look at the Global Financial Crisis that began in 2007. In the video, Paul and Peter discuss how the subprime mortgage began and explain some of the mistaken assumptions that the banks made in their new forms of financial engineering. This article then explains in more detail how the crash happened, and how it spread around the world.

How the crash happened

By 2006 some of the risky homeowners inevitably began to default on their loans. The supply of available housing now began to outstrip demand, a result of the wave of new building developments from Las Vegas to Ireland. House prices started to collapse. The value of the property that had provided collateral for the loans plummeted. Suddenly lots of investors were left holding pieces of paper for financial instruments whose value was far from clear. The investment banks had turned themselves into machines for generating and offloading these securitised loans. But none of them knew exactly what toxic assets they had on their own books. And they certainly didn’t trust what other banks might have lurking on their balance sheets. Banks started calling in loans, both from other financial institutions and from business customers.

The credit crunch

Credit dried up, and the whole highly financial system came to a grinding halt in September 2008. There was a run on the UK bank Northern Rock (that had got heavily into subprime loans), and the American investment banks Bear Stearns and Lehman Brothers collapsed. The crisis spread to other parts of the financial world. It was a house of cards that was in danger of complete collapse.

The weak suffer what they must?

As the entire financial system threatened to implode, the British and American governments stepped in. They created a massive bail-out of troubled banks, as well as a trillion-dollar economic stimulus plan. Even that was not enough to stop the crisis from spreading globally. Many countries around the world found themselves the casualties of a sovereign debt crisis. The banks that had been lending to countries such as Greece, Ireland and Italy began to get cold feet. They worried that those countries were the equivalent of delinquent homeowners, about to default on their loans. In a number of European countries, central banks lent vast sums to the governments keep them afloat. That allowed countries such as Greece and Ireland to pay back their loans to the big investment banks, most of which survived intact and didn’t suffer significant losses. But at the end of the day, it is ordinary citizens in those troubled countries who are paying the price for bailing out the banks. Large slices of tax revenues are taken up with repaying government debt.

  • What do you think was the main cause of the crash in 2008?
  • Do you think the crash was inevitable?
  • What could have been done to prevent it?
  • Why did the crisis spread to so many countries?

Further reading

This article is from the free online

Understanding Money: the History of Finance, Speculation and the Stock Market

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