Your 4-Step Guide to Understanding the 2008 Financial Crash & Subsequent Recession — From a Modern Monetary Theory (MMT) Perspective
Politicians on both sides of the Atlantic are once again talking about rolling back banking regulations to kick-start growth. This article is a timely reminder of why those regulations exist.
On 15 September 2008, the investment bank, Lehman Brothers collapsed causing the largest bankruptcy in US history. I remember watching ‘the action’ on my TV: employees were leaving the building with their belongings in cardboard boxes and reporters were talking about ‘sub-prime mortgages’ and ‘Collateralised Debt Obligations (CDOs)’, as if we all knew what these phrases meant. Lehman Brothers wasn’t the first bank to get into trouble, Bear Stearns had already collapsed in March but it was the fall of Lehman Brothers that started the panic. It triggered a global banking crisis, a stock market crash and an economic downturn. As a result, million of people lost their jobs, their homes, and their savings.
In this article, I pick apart the reasons for this catastrophic implosion of the global financial system. I’ll break it down into four, not alway so simple, steps. Four steps to financial disaster:
Step One: Financial deregulation.
Step Two: The development of new financial ‘instruments’ that resulted in undermining attitudes to risk in relation to mortgage lending.
Step Three: The build up of private sector debt.
Step Four: The inability of orthodox economic analysis to understand the causes and therefore, predict the outcome. A situation that hasn’t completely changed even today.
For the moment, I will concentrate only on the first two steps, i.e., financial deregulation and the development of new financial ‘instruments’ and their effects on the mortgage-lending market. In my next article on this topic, I’ll cover private sector debt and the inability of orthodox economics to either understand or predict these catastrophic events. Note: MMT and many MMT adjacent economist (for example Post Keynesian economists), correctly predicted the crash.
First, here’s a short summary: deregulation gave freedom to creative, ‘big-brained’ finance experts to dream up new ways to make profits for their employers. In the context of a fragile financial system with historically high private sector debt, those innovations encouraged risky behaviour. That risky behaviour pushed an already unstable system over the edge, leading to its collapse. Lenders—many of whom should never have been sold home loans in the first place—were unable to pay the interest on their loans. Meanwhile, investors who had been sold new ‘innovative’ financial products on the back of those loans lost the income they had expected to receive. When house prices started to fall in 2006, ‘the game was up,’ so to speak.
After the 2008 financial collapse, tighter financial regulations were introduced across the world to help prevent future meltdowns.
Are Those Regulations Now Getting in the Way of Growth?
Memories appear to be short. Today, politicians in both the UK and US are once again pushing for financial deregulation. In an address to the financial industry, UK Chancellor Rachel Reeves said that crisis-era regulation has 'gone too far’ and that “changes have resulted in a system which sought to eliminate risk-taking.” Meanwhile, in the US, Donald Trump is expected to take a flamethrower to Wall Street regulation.
Given the messages coming out of both the UK and US governments, this is a good time to remind ourselves of the factors that lead to the 2008 financial crisis and the disastrous aftermath. Because: clearly, lessons aren’t easily learned. But first we need some context. Let’s start our journey by reminding ourselves of an earlier historical financial meltdown.
The Context: The Great Depression of the 1930s
To understand the 2008 financial crash, we could start from any point in the last 250 years (Adam Smith’s ‘The Wealth of Nations’ was published in 1776) - but I need to keep it concise, so, we’ll start from The Great Depression of the 1930s.
The global economic crisis of the 1930s was triggered by the 1929 Wall Street crash: a collapse in stock market prices that wiped out the wealth of most investors. Over the next three years (1930 through 1933) this led to bank collapses, savers rapidly withdrawing their money from banks; businesses that couldn’t repay loans and banks that found themselves unable to cover their loses.
The result of this cascade of bank and business failures was mass unemployment. As the symptoms of the initial crash were exacerbated by poor government decisions. By 1933, in both the U.S. and the UK the unemployment rate soared: to a peak of approximately 25% in the US and 22% in the UK.
Post-crash government decisions included: austerity policies; the imposition of high tariffs on imports (which ultimately shrank global trade as other countries retaliated), interest rate increases and tax increases. These government actions reduced both consumer spending and business investment: the exact opposite of what was needed to get the economy growing and people back into work. Government decisions, rooted in orthodox economic approaches, exacerbated the problems.
The Introduction of Stronger Financial Regulation
Just as with the later 2008 financial meltdown, the response to the 1929 crash (and subsequent economic depression), was the introducing of legislation designed to make the financial sector more robust. In the US, changes included the Glass-Steagall Act (1933), which separated commercial banking from investment banking to prevent risky speculation affecting customer deposits, tighter capital and reserve requirements and the Banking Act of 1935, which strengthened the Federal Reserve’s control over monetary policy, giving it more power to regulate credit and banking practices.
Similar regulations were introduced in countries around the world. For example, in the UK, banking regulations were strengthened, and the Bank of England took a more active role in overseeing financial stability.
These stricter financial regulations helped stabilise the financial system for several decades; preventing reckless speculation and excessive risk-taking. They helped make the banking sector more resilient.
So, that’s all good. Or it was, up until the point when politicians and economists start to believe that these restrictions were no longer necessary. This was another one of those points in history where economists were confident that they had ‘solved economics’: through their years of study they felt they now knew how to manage the economy to maintain stability. They knew how to steer the economy back on course when it strayed. So, this, they believed, was also the point where these old regulations could be removed, because, all they did was stifle growth. What was needed instead was to free up the potential of the country’s talented entrepreneurs.
“macroeconomics…has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved” Nobel-Prize winner, Robert Lucas (2003)
“the global economy remains on track for continued robust growth in 2007 and 2008.” IMF (2007)
They were wrong, of course. In relation to the inherent danger that way within these beliefs I would refer you to the work of Hyman Minsky’s how coined the phrase, ’Stability Breeds Instability’.
We have reached step 1 on our road to financial meltdown; the dismantling of the post-1930 depression legislation.
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Step 1: The Dismantling of the Financial Regulations Put in Place After the 1930s Financial Crash
The ‘New Keynesians’ Are in Control
With the arrival of centre-left governments in the 1990s in both the UK and US (Tony Blair’s New Labour and Bill Clinton’s New Democrats) macroeconomics was dominated by the ‘New Keynesians’ . New Keynesians were not keen on using fiscal spending as a primary policy tool. They agreed that deficits were acceptable in the short term when needed, but over the long run, they felt that balanced budgets should be the goal.
Their preferred tool was monetary policy (interest rates changes). They saw it as a quicker and more flexible way to manage the economy—unlike fiscal policy (spending and taxing), which took too long to have any effect. So, for New Keynesians, governments and central banks should keep the economy stable by adjusting interest rates: as their preferred way to tackle inflation. And crucially for our story, they were in favour of financial deregulation, believing that banks played a crucial role in driving economic growth. From their perspective, it is banks that provide the capital to entrepreneurs, investors, and businesses—and these were the ‘engine’ of the economy.
Deregulation, therefore, was on the agenda from the 1990s Onward.
The Implications of Weakened Financial Regulations
Repeal of the 1933 Glass-Steagall Act (effectively repealed in 1999 combined with the Commodity Futures Modernisation Act in 2000, allowed banks and other financial institutions to once again indulge in risky behaviour. For example, they were able to design financial products that allowed them to get around capital adequacy restrictions. I provide more details below, but in summary, they were taking mortgage loans off their balance sheets by selling them to investment banks. This allowed them to service more mortgage customers than would normally have been the case. And crucially, it lowered their perception of the risks they were taking when providing mortgages to customers.
What was The 1933 Glass-Steagall Act. The 1933 Glass-Steagall Act was a US law designed to separate everyday banking from more risky investment activities. It was enacted after the Great Depression of 1929/30 as it was seen as way to help prevent a recurrence of future financial crashes. The Glass-Steagall Act was effectively repealed in 1999 by the Gramm-Leach-Bliley Act.
What was The Commodity Futures Modernisation Act 2000 The Commodity Futures Modernisation Act 2000 was a US law that removed regulations that made it easier for banks and financial institutions to buy and sell complex financial products without government oversight.
The removal of regulations, designed to keep risky behaviour by banks in check, set the scene for the development of new financial products - products that played a role in the 2008 financial collapse.
Step 2: The Development of New ‘Financial Instruments’
The unraveling of the ‘post the 1930s crash legislation’, meant mortgage providers could provide their mortgages to individuals, without worrying quite so much about their credit worthiness.
Mortgage lenders where winning on ‘both ends of the lending process’: firstly these new products allowed them to outsource the procurement of mortgage customers, via brokers (who were on commission and, therefore, incentivised to find new customers and they’d still get paid even if those loans ‘went south’ later). Secondly they were winning the post-mortgage process: because they could offload the resulting mortgages to investment banks - removing potentially risky assets from their books.
Selling mortgages rather than keeping them on the books generated lower returns over the life of each loan. However, offloading risky assets allowed them to issue far more mortgages than they otherwise could. As a strategy this was more profitable and ‘safer’ for the mortgage lender. They had no need to worry about whether mortgage holders would default: now that was for the investment banks to worry about. Or, so they thought.
What are ‘Capital adequacy restrictions’? Capital adequacy is a measure of a bank's or other financial institution's ability to pay its debts – expressed as percentage of the banks (or other financial institutions) 'risk-weighted' assets– in the event of a crisis. The phrase ‘risk weighted’ is used because not all assets are created equal. Some assets are safe, like cash or short-term government bonds and some are not so safe, like investments in private sector companies stocks. Capital adequacy restrictions are the rules that require banks to hold a certain amount of money/liquid assets in reserve to cover potential losses, to ensure they remain financially stable in the event of economic shocks. In the US, capital adequacy restrictions were primarily governed international banking regulations called, the Basel Accords (Basel I, II, and later III), and were enforced through regulations like the risk-based capital requirements set by the Federal Reserve.
I mentioned Collateralised Debt Obligations (CDOs) in my opening paragraph. I neglected tell you what they were. That time has come. To understand the 2008 financial crash we need to understand the dangerous world of CDOs, securitisation, the sub-prime mortgage market, NINJA loans, Load Doc loans and more.
Understanding the Sub-prime Mortgage Market
This new ‘post-financial-restrictions’ environment led to the growth of the sub-prime mortgage market. In other words the market that consisted of people who wanted a mortgage but had poor credit ratings. ‘Collateralised Debt Obligations’ facilitated that growth.
A ‘Collateralised Debt Obligation’ (CDO) is a financial product created by bundling together loans—such as mortgages, corporate debt, or other credit—into packages (or ‘tranches’ as they called them) that can be sold to investors. The idea is that these bundles generate income for investors as borrowers make their loan payments. Investment banks who create and sell CDOs, often structure them into different packages aimed at investors with varying appetites for risk: the riskier the package, the higher the potential returns. Buyers of CDOs ranged from hedge funds to pension funds and local councils looking for steady returns.
What does The Sub-Prime Mortgage Market mean? The Sub-Prime Mortgage Market is the market for providing loans to people with poor credit histories. As you would expect, individuals within this target group are more likely to default on their payments.
What does Collateralised Debt Obligations (CDOs) mean? Collateralised Debt Obligations (CDOs) are bundles of loans, like mortgages, that are packaged together and sold to investment banks, who package those mortgages up to make money as long as borrowers keep paying–but lose out if too many people stop their loan repayments.
What is an asset-backed security? An asset-backed security is a tradable financial asset. CDOs are asset-backed securities (ABS) because they are backed by pools of loans (such as mortgages, corporate debt, or other credit products). Asset-backed can also be backed by other things such as student loans or car loans.
How It All Went Wrong: High Level of Private Sector Dept and The End of The Housing Bubble
“By 2007, the US was a very fragile financials system needing only a small downturn to bring it crashing down” Economist Steven Hail
In this story of human woe, we have arrived at the point where, the house of cards fell, the wheels came off, the foundations gave way and the levee finally broke.
In the years prior to the 2008 crash, there existed a financial system in the US (and around the world) that allowed mortgages to be sold to individuals who where not in a position to service those mortgages. Those mortgages were being sold on the assumption that house prices would continue to rise. Both lenders and borrowers appeared to believe that house prices would continue to rise, protecting them from any potential losses: higher house prices meant lenders might even walk away with a small profit even if they could not service their loans and had to sell.
As a result this confidence in rising prices, a host of different types of mortgage loans were created designed to sell directly to the sub-prime market. Here are few of the more colourfully name mortgage products being sold.
‘NINJA’ loans NINJA stands for 'no income, no job, no assets’. This - as the name suggests was type of subprime mortgage given to borrowers without requiring proof of income, employment, or assets.
‘Low doc’ loans. i.e. loans that did not require supporting documentation.
‘Teaser rate’ loans. A teaser rate loan is a loan that starts with a low interest rate (or a zero interest rate) and reverts to a standard interest rate after a designated period of time. For example, after two years interest on the loan would be charged at the market rate. This allowed people who could not pay back even the minimum interest to purchase a property. As mentioned above, the assumption being that by the time they needed to pay the interest the house would have risen in value–or they could just ‘roll over their loans’ by taking out another teaser loan at the low rate.
In 2006, House Prices Started to Fall
But house prices did not continue to rise. The housing bubble burst in 2006 and continued its downward trajectory throughout 2007. The housing market collapsed. As a result peopled started to default on their mortgage loans (this was also a time of historically high private sector debt). And those organisations and individuals who had invested in the new Collateralised Debt Obligations (CDOs) and other investment vehicles found that they were no longer getting any income from those financial products.
The end was nigh for CDOs and for the economy. And sadly, as I mentioned earlier, once again the UK government prolonged the recession by choosing austerity policies over government spending to support the private sector. Whereas, the US economy officially emerged from recession in mid-2009, the UK’s GDP did not return to pre-crisis levels until 2013.
15 September 2008: Lehman Brothers Collapses and the Global Banking Crisis Begins
We have arrived back where I began this article. On 15 September 2008, the investment bank Lehman Brothers collapsed, and I sat watching the carnage on my TV screen.
In article two, I will cover private sector debt and the inability of orthodox economic analysis to understand the causes as we seek to understand the 2008 financial crash & subsequent recessions.
That’s all for now.
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