Executive Summary

The financial crisis began in early 2006 when the subprime mortgage market in the U.S. began to display an increasing rate of mortgage defaults.  These defaults lead, in late 2006, to a decline in US housing prices after nearly a decade of exceptionally high growth.  Many Americans watched as their primary source of wealth become increasingly devalued.  By late 2007, the prime mortgage markets were showing higher than normal default rates as well.

Collateralized Mortgage Obligations (CMOs), a type of collateralized debt obligations (CDOs), allowed these problems to spread from the mortgage market to other sectors of the economy, having especially widespread effects on financial markets as a whole. CMOs were mortgage-backed securities issued by investment banks and other financial institutions, which since they were not part of the commercial banking system, were allowed to operate unregulated by the federal government. As the value of mortgages fell due to increasing default rates, the value of these securities fell likewise.

The problem was compounded by another financial product, the Credit Default Swap (CDS).  CDSs were nominally insurance contracts on CMOs, but they became a tangled web which dragged the financial system down as sellers of CDSs bought matching CDSs to protect themselves against default risk until nearly all the players in the investment banking market were linked together by these liabilities.

These CMOs and CDSs became the infamous “toxic assets”.   The defaults in the mortgage markets caused a collapse in the value of the corresponding CMOs, which created a cascade of additional problems as the multitude of CDSs were executed, dragging down the balance sheets of the major players in investment banking.  It was this that lead to the freezing of private credit markets.  The collapse in value of CMOs lead to a significant problem: since no one was trading CMOs, it was no longer clear what they were worth.   The financial system is based on trust.  The evaporation of trust meant that no private financial institution was willing to lend its scarce cash to any other since the former couldn’t trust that the latter was correctly revealing the extent of its CMO holdings, and neither could be sure what those holdings were worth.

These liquidity problems turned to insolvency in September of 2008, when private lending froze completely in a number of important credit markets, such as commercial paper. As a result, non-financial businesses were unable to get access to the financing they required to function normally, leading to problems in the real economy.

The real economy began to exhibit problems related to the financial crisis as early as March 2006, when investment expenditure on residential structures began to decline.  In early 2008, this decline spread to investment in business equipment and consumer spending on durable goods.  It wasn’t until the summer of 2008 that consumer spending broadly and GDP began falling, signs of a recession.  (In December 2008, the National Bureau of Economic Research, official arbiter of business cycles dated the formal beginning of the recession as December 2007.)  While the public had been concerned about recession for much of the year, it wasn’t until the fall that the economy began to decline at more than a 6% annual rate.  Congress responded by passing the TARP plan to assist failing financial institutions. This plan was meant to decrease the severity of the recession by treating its cause: the financial crisis.

The financial crisis and recession in the U.S. spread globally through both financial and trade linkages.  Seeing housing prices in the U.S. rising, foreign banks sought opportunities to invest in the U.S. housing market, such as through CMOs issued by investment banks. When the mortgages backing these securities began to fall in value, the value of the securities themselves began to fall. Seeing their asset prices falling, investors attempted to liquidate their holdings beginning in August of 2007. These assets became frozen because of a lack of buyers in the market.  As credit became scarce and in response to a lack of confidence in U.S. financial institutions, international banks began to raise the interest rate at which they lent money to one another, known as the LIBOR.

Additionally, the economic slowdown in the U.S. led to declining U.S. imports from its major trading partners, the European Union, Mexico and China.  When export sales languished, foreign GDPs fell too, spreading the recession worldwide.  Despite recent claims that the US is no longer the locomotive of the world economy, the current crisis shows those claims to be false.