The worldwide financial crisis which commenced in 2007 worldwide followed a period of over 10 years of relatively low inflation and interest rates. In the United States, interest rates were maintained at a low rate, following the bursting of the so-called “dot.com” bubble. In Europe interest rates were maintained low, while Germany emerged from a period of recession and d slow growth caused by the effects of unification. Asset prices began to rise rapidly, particularly in Ireland.
Trade imbalances between the United States and in particular China which maintained its currency at an artificially low level, created enormous surpluses which were invested in low-risk securities reducing their yield to historic levels. The plentiful liquidity enabled investors to seek higher returns as yields or returns on safe conventional fixed interest assets, reached historically low levels. Monies were allocated to inappropriately risky assets with the objective of seeking higher returns, apparently without proper recognition of the risk factors attaching to them.
Bank funding, which had lately relied almost entirely on deposits, came to rely increasingly on debt securities and other sources of funding due to increased innovation and intermediation in money markets. The innovation of securitisation enabled banks to lend greater quantities of money, by packaging and selling their loan assets as securities. This facilitated ever-increasing lending and led to degradation in lending standards.
Securitisation in the United States and governmental housing policy encouraged the growth of so-called “sub-prime” real estate lending. Lenders reduced underwriting standards because were not retaining ownership of the loans. Many loans were underwritten on the basis of collusion and fraud by intermediaries and lenders.
Rating agencies rated securities highly based on flawed risk analysis. Bank bonuses and profitability was directly linked to increased lending. It was believed that the market would automatically price risks. Failures of the type that occurred, were assumed by risk models to be highly unlikely.
In mid-2007, the United States Federal Reserve Bank finally increased interest rates after nearly four years of historically low rates. This quickly exposed the frailty of many housing loans and the securities based on them. Default rates increased rapidly on the housing loans Even the top prime layers of asset-backed securities, which were assumed to have tiny risk and be equivalent to high investment grade were quickly exposed as highly risky and flawed. These securitised assets were held by financial institutions worldwide.
In the United States, institutions began to lose confidence in the financial strength of other institutions, whose ability to repay might be undermined by the possibility or fact of holding so-called “toxic assets”. Impairment of housing and other packaged risky loans (generically, so-called collateralised debt obligations) accelerated. A downward spiral occurred in their value.
In Europe, more and more lenders became reliant on short-term lending from other financial institutions as increasing financial sophistication and intermediation reduced the availability of deposits. The presence of toxic assets on the balance sheet and general evaporations of confidence in the value banking assets led to a lack of confidence in counterparties in the banking market.
Northern Rock, a North of England mortgage bank that had grown exponentially in reliance on the interbank market, became the subject to the first UK or Irish bank run since the middle of the 19th century when depositors lost faith in its ability to meet its obligations.At the same time, a following property market in Europe and the United States further undermined confidence in the mortgages and loans, constituting the banks’ asset and backing their ability to repay customer deposits and other liabilities.
In the United States two private, but state-promoted mortgage entities, Fannie Mae and Freddie Mac which purchased the securities, particularly housing loans of smaller banks, were placed into insolvency protection and required United States Government support. The global investment bank, Bear Stearns collapsed in March 2008 and was sold to a rival in a hastily organised sale.
In September 2008 in the United States, Lehman Brothers a giant investment bank was placed in insolvency protection and the United States Federal Reserve chose not to intervene. The immediate consequence was a sharp collapse in confidence between financial institutions and a worldwide funding crisis. The inter-bank market froze as the “credit crunch”, which had been brewing for over a year, became almost total.
The effects of the credit crunch were felt worldwide. In a short period of weeks, in September to October 2008, Governments worldwide took dramatic and unprecedented steps to prevent the collapse of the financial system.