In the early 2000s, US real estate seemed irresistible, and a heady run-up in prices led consumers, banks, and investors alike to load up on debt. Exotic financial instruments designed to diffuse the risks instead magnified and obscured them as they attracted investors from around the globe. Cracks appeared in 2007 when US home prices began to decline, eventually causing the collapse of two large hedge funds loaded up with subprime mortgage securities. Yet as the summer of 2008 waned, few imagined that Lehman Brothers was about to go under—let alone that it would set off a global liquidity crisis. The damage ultimately set off the first global recession since World War II and planted the seeds of a sovereign debt crisis in the eurozone. Millions of households lost their jobs, their homes, and their savings.27:29AudioHow secure is the global financial system, a decade after the crisis?Great strides have been made since 2008 to prevent a recurrence of the financial crisis and recession that followed. Yet there is more debt than ever in the global financial system.
The road to recovery has been a long one since those white-knuckle days of September 2008. Historically, it has taken an average of eight years to recover from debt crises, a pattern that held true in this case. The world economy has recently returned to robust growth, although the past decade of anemic and uneven growth speaks to the magnitude of the fallout.
Central banks, regulators, and policy makers were forced to take extraordinary measures after the 2008 crisis. As a result, banks are more highly capitalized today, and less money is sloshing around the global financial system. But some familiar risks are creeping back, and new ones have emerged. In this article, we build on a decade of research on financial markets to look at how the landscape has changed.
- Global debt continues to grow, fueled by new borrowers
- Households have reduced debt, but many are far from financially well
- Banks are safer but less profitable
- The global financial system is less interconnected—and less vulnerable to contagion
- New risks bear watching
According to the USA Today article, growing concern over the spread of the coronavirus is sometimes linked to the Great Recession of 2007-2008. The article cited the dips in the stock market, federal interest-rate cuts, and government stimulus programs as parallels between today and then. “It’s beginning to look a lot like 2008 again,” the article said. “And not in a good way.”
However, despite these similarities, the article pointed out that there are also several differences between 2020 and 2008. “For one thing, the 2008 financial crisis and recession resulted from years of deeply rooted weak spots in the economy,” the article said. “That’s not the case now.” It went on to list the differences in cause, household debt, job loss, and other factors. With 2008 fading into memory, it’s a good time to brush up on the mortgage crisis.
Comparing the current economy amid the coronavirus outbreak to the 2008 financial crisis and recession is not apples-to-apples, USA Today reported. Here’s what made 2008’s financial crisis different.
Mortgage Pools
One of the contributing factors to the Great Recession was the abuse of mortgage pools. How do mortgage pools work?
“Banks and other financial institutions throw a bunch of mortgages into a pot and then sell claims on its earnings,” said Dr. Ramon Degennaro, CBA Professor in Banking and Finance at The University of Tennessee, Knoxville. “It’s like a mutual fund for mortgages. Home buyers get better access to loans, banks can manage their risks by selling some or all of their loans, and investors get access to a new, diversified investment tool with nice characteristics.”
Dr. Degennaro said that the correlations among loans in mortgage pools were much higher than expected, which raised risk. Widespread defaults on mortgages also turned the mortgage pools tepid.
“Delinquency rates on some prime mortgages by age and by date of origination, as of summer 2008, make that plain,” Dr. Degennaro said. “For loans made in 2003, delinquency rates after 18 months were a bit over five percent. For 2005, it was about 10 percent. For 2006, it was over 20 percent.
“For 2007, it was at least 25 percent.”
Glaring warning signs like this should’ve been an obvious red flag for the financial institutions issuing home loans to people who could never pay them back, but they weren’t.
Easy Money
Aside from private lending firms, the Federal Reserve System made mistakes, too, including not following what’s known as the Taylor Rule.
“Named for its developer, John Taylor of Stanford University, the Taylor Rule tells policy makers what the federal funds rate should be, using current inflation and the relationship of gross domestic product to its long-term trend,” Dr. Degennaro said. “The Fed did a rather good job of applying the Taylor Rule until about 2001—not so good after that. The Fed held rates too low relative to the Taylor Rule from 2002 through 2006.”
When rates finally did increase, Dr. Degennaro said, they were too sudden. This also caused another problem—lax underwriting laws. Like private institutions, federal banks granted housing loans to people who could never pay them back.
“Politicians would prefer not to give money directly to people with bad credit,” Dr. Degennaro said. “Instead, they encourage banks to make loans to people with bad credit at below-market rates. Then, if the loans go bad, they bail out the banks with programs like the Troubled Asset Relief Program.”
Dr. Ramon P. Degennaro contributed to this article. Dr. Degennaro is the CBA Professor in Banking and Finance at The University of Tennessee, Knoxville. He also served as a Visiting Scholar at the Federal Reserve Banks of Cleveland and Atlanta and for the American Institute for Economic Research. Professor DeGennaro holds a Ph.D. in Finance from The Ohio State University.
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