INTRODUCTION

During the Credit Crisis of 2007–2009 the failure or financial distress of many large global institutions caused reverberations across the global financial markets and economies, leading to deep recessions in the United States and continental Europe. Although the crises technically began in 2007, it wasn't until the Fall of 2008, with the failure, emergency bailout, or acquisition of some of the world's most recognizable firms such as Lehman Brothers, Bear Stearns, and American International Group Inc. (AIG), that the systemic impact of the crisis fully emerged.

This crisis has been referred to by several different labels, including the U.S. Subprime Crisis, the U.S. Housing Bubble, the Great Contraction, the Great Recession, the Global Credit Crisis, to name a few. Regardless of the name used, given the dramatic impact the event had on the global financial system and economies, this event is generally viewed as the worst financial crisis to occur since the Great Depression.

While in the years following the Credit Crisis many theories and opinions have emerged about its causes, it is generally acknowledged that the bursting of the U.S. residential housing bubble was the primary driver of this global financial meltdown. The U.S. residential housing market experienced a dramatic run-up in home prices between the years of 2000 and 2006, increasing by 100%, followed by a decline of over 30% during 2006–2010.¹ Dating all the way back to 1891 (e.g., inception of the S&P's Case-Shiller Housing Price Index), there was no other comparable increase in housing prices to that which occurred in the several years preceding the start of the Credit Crisis.

After reading this chapter you will be able to:

• Understand the economic, financial, and regulatory conditions that collectively led to the Credit Crisis.
• Explain the key ways in which activities of certain Wall Street investment banks contributed to a tremendous bubble in subprime mortgage bonds.
• Learn how U.S. government-sponsored enterprises and investment banks helped fuel tremendous growth in residential mortgage securitization products.
• Understand what circumstances led to the insolvency or government bailout of many large financial institutions.
• Explain the basic structure of credit default swaps and collateralized debt obligations.
• Explain the aftermath of the Credit Crisis in terms of its economic impact on the United States and Europe.

PLANTING THE SEEDS OF A BUBBLE: THE EARLY 2000s

There is ample evidence showing the linkage between the U.S housing boom, a significant inflight of cheap foreign capital due to record trade balance and current account deficits, loose monetary policies, and weak bank lending standards during the early to mid-2000s.²

In the years preceding the start of the Credit Crisis there were a few prominent public figures that either dismissed or countered concerns about an overheating U.S. economy. For example, in response to those who pointed to the growing U.S. current account deficit (which peaked at over 6.5% of GDP or over $800 billion in 2006), former Federal Reserve Bank Chairman Alan Greenspan characterized this as a symptom of a trend around the globe that allowed countries to maintain bigger current account deficits and surpluses than in the past.³ Similarly, former U.S. Treasury Secretary Paul O'Neill argued that it wasn't unusual for countries to provide significant flows of capital to the United States given its high rate of productivity. Lastly, Ben Bernanke attributed the high level of U.S. borrowing to a global savings excess that occurred because of many factors outside the control of U.S. policymakers.⁴

Another of the many contributors to the Credit Crisis was the impact of “fair value” or “mark-to-market” accounting rules. FAS 157 provides a way to measure assets and liabilities on a company's balance sheet and record changes in value of those assets in the income statement. FAS 157 defines fair value as the price that would be received to sell an asset in an orderly transaction between market participants. Tremendous losses reported by banks and investment banks on subprime mortgage assets led a rigorous debate in the United States over the implementation of FAS 157 in such a unique market situation in which an orderly and liquid market simply did not exist. Critics also blamed FAS 157 for causing pro-cyclicality during the crisis in that asset prices were falling dramatically on their own and were then exacerbated by banks being forced to write down subprime mortgage securities in such a downward-spiraling market.

Proponents of the rule, including the Securities and Exchange Commission (SEC), opined that FAS 157 provided investors meaningful and transparent financial information. Opponents, such as William Isaac, former FDIC chairman, went on record publicly stating that this rule caused the Credit Crisis:

The devastation that followed stemmed largely from the tendency of accounting standards-setters and regulators to force banks, by means of their litigation-shy auditors, to mark their illiquid assets down to unrealistic fire-sale prices.⁵

Mark-to-market accounting led to an estimated $500 billion loss in capital in the United States, and when the impact of leverage is considered, such rules led to a $5 trillion destruction in bank lending capacity.⁶ Ultimately, the rule was relaxed to allow banks to exercise judgment in estimating a liquidation price. A report by the Financial Crisis Advisory Group in 2009 concluded that “accounting standards were not a root cause of the financial crisis,” but did acknowledge that weakness in the application of the rules reduced credibility in financial reporting.

Ahead is a short list of some of the commonly discussed characterizations or assumptions that contributed to the Credit Crisis and allowed many to conclude that there was no imminent threat of a financial meltdown:⁷

• Since the United States had a very robust financial regulatory regime, the most advanced and liquid capital markets in the globe, and an extremely innovative financial system, it could withstand the huge inflows of capital that were occurring.
• Expansions in financial integration globally meant that capital markets were deep enough to permit countries like the United States to go heavily into debt.
• The United States has superior monetary policymakers and institutions.

According to some, the Federal Reserve (the Fed) could have been more aggressive in addressing what in retrospect was clearly an overheating U.S. economy in the years leading up to the Credit Crisis.⁸ For example, one of many potential actions might have been to utilize the Taylor Rule, which is a theory that real interest rates should be raised to cool the economy when inflation increases (requiring the nominal interest rate to increase more than inflation does). Specifically, the Taylor Rule says that an increase in inflation by 1% should prompt central banks to raise the nominal interest rate by more than 1%. Since the real interest rate is (approximately) the nominal interest rate minus inflation, stipulating a_π>0 implies that when inflation rises, the real interest rate should be increased.

The Taylor Rule involves just three variables: inflation rate, GDP growth, and the interest rate. If inflation were to rise by 1%, the proper response would be to raise the interest rate by 1.5% (Taylor explains that it doesn't always need to be exactly 1.5%, but being larger than 1% is essential). If GDP falls by 1% relative to its growth path, then the proper response is to cut the interest rate by 0.5%.

A sharp boom and bust in the housing markets would be expected to have had impacts on the financial markets as falling house prices lead to delinquencies and foreclosures. These effects were amplified by several complicating factors, including the use of subprime mortgages, especially the adjustable rate variety, which led to excessive risk taking. In the United States, this was encouraged by government programs designed to promote homeownership.

It is important to note, however, that the excessive risk taking and low interest rates or “easy credit” monetary policy decisions are connected. Empirical evidence supports the idea that government actions and interventions caused, prolonged, and worsened the financial crisis. They caused it by deviating from historical precedents and principles for setting interest rates, which had worked well for the preceding 20 years.

WALL STREET'S ROLE

The financial sector in general, and more specifically, U.S. investment banks, took a significant amount of blame for the Credit Crisis. The size of the U.S. financial sector more than doubled from an average of about 4 percent of GDP in the mid-1970s to almost 8 percent of GDP by 2007.⁹ Financial innovation had also been rapidly on the rise during the 2000s, with asset securitization representing one of Wall Street's most popular and profitable products.

Securitization represents the aggregation of numerous, sometimes thousands of individual loans into a newly created asset-backed securities (ABS). The benefits of securitization to investors lie in the concepts of pooling and tranching. For example, since typical ABS may be comprised of thousands of individual loans, the default on a few loans would have a minimal impact on the overall performance of the security. With tranching, investors could choose which layer of risk and expected return they are comfortable with. For example, a senior tranche would have a higher priority in the receipt of principal and interest payments on the underlying loans versus a more junior tranche and would only absorb defaults after lower tranches first took losses.

While Fannie Mae and Freddie Mac historically dominated the securitization market for fixed-rate mortgage loans for decades, during the mid-1980s Wall Street firms began to securitize other types of loans, such as adjustable-rate mortgages (ARMs) and others that the GSEs were either unwilling or unable to securitize under their rules. Wall Street firms bundled loans they purchased from banks and other lenders into new securities that were sold to investors who earned returns funded by the principal and interest payments on the underlying loans.

The types of ABS created by Wall Street in the early years were more complex than the more generic residential mortgage-backed securities (RMBS) created by the GSEs, as the former were comprised of many different and sometimes riskier loan types. The overall ABS securitizations grew tremendously during the 1990s and included securities comprised of assets such as student loans, manufactured housing, residential loans (mortgages and home equity loans), credit cards, and automobile loans. By 1999 the securitization market grew to $900 billion from approximately $50 billion in 1990 (excluding securitizations by the GSEs).¹⁰ Between 2003 and 2007, U.S. home prices rose 27% and $4 trillion of RMBS were created, from which Wall Street launched approximately $700 billion of mortgage-backed CDOs.¹¹

One of the earliest and most popular forms of securitization is called collateralized debt obligations (CDOs). CDOs were often used by banks to prudently move loans into newly created structured entities that were held off-balance-sheet. Although banks typically retained some degree of risk in the CDO, they benefited greatly by reducing their direct loan exposures and freeing up capital to reinvest in new loans or other revenue-generating activities.

Beginning in the early 2000s, Wall Street financial engineers at many investment banks began to make use of CDO-type structures much more frequently. Many of these structures had corporate bonds as their underlying collateral. However, as the U.S. residential mortgage market exploded during the period of 2004–2007, investment banks began to create and aggressively sell variations on the more generic corporate CDO structure. These were called synthetic CDOs and they often had a much riskier profile than CDO offerings from earlier years.

The CDOs were classified as synthetic since they were not created or funded by actual bonds but rather credit default swaps (CDSs) that were sold or “written” on the underlying cash bond instruments. A CDS contract was less like a traditional swap contract and more akin to an insurance contract. For example, an investor may pay $100,000 a year to buy $100 million of five-year CDS on General Motors (GM). In this example, the CDS buyer can only lose a total of $500,000 ($100,000 annual premium × 5 years) and can make a maximum of $100 million should General Motors default (assuming zero recovery value on the underlying bonds). Meanwhile, the seller of any CDS contract can only earn a maximum of the $500,000 of total premiums received, but can lose $100 million in a worst-case scenario.

In the early years of CDS activity most trading was for hedging purposes. For example, if a firm felt that GM had a high risk of credit default, they might purchase CDS “protection” that would pay them upon a GM credit event. However, in the years leading up to the Credit Crisis more and more firms began using CDS to speculate on firm defaults rather than the more conservative practice of hedging against such events.

While many variations of RMBS collateral existed in the market at that time, the percentage of subprime securities¹² began to increase dramatically and became an ever-increasing proportion of new synthetic-CDO collateral pools. To provide a sense of the growth in subprime mortgage origination and the linkage to CDOs, in 2000 there was $130 billion of subprime origination of which $55 billion was repackaged into RMBS. In 2005 there were $625 billion of subprime originations of which $507 billion became RMBS.¹³

Even though a growing percentage of the CDO reference collateral was below investment grade, by repackaging these securities into new CDO tranches, they could be sold to investors with ratings that usually ranged from BBB all the way to AAA. This was possible because the ratings were based largely on the level of subordination or loss absorption beneath each tranche. For example, an A-rated tranche investor might not suffer any losses unless 15% of the total collateral pool defaulted. An AA tranche might have subordination of 25%, and so on. As such, owners of these tranches felt they were taking very little risk due to the very strong public ratings assigned by rating agencies. However, the collateral that was supporting their investment often contained very low-rated individual bonds made to subprime borrowers. For example, most subprime-backed CDOs were created by the lowest rated tranches of RMBS (mainly B and BB). Such risky mortgage loans were effectively transformed into highly rated CDO tranches due to perceived benefits imbedded in the typical waterfall structure of CDOs.

The creation of synthetic CDOs became an extremely big business for Wall Street as they could earn tremendous fees for structuring and selling these investments. Between 2003 and 2007, during a period in which home prices rose 27% nationally and $4 trillion of mortgage-backed securities were created, about $700 billion in CDOs were issued by Wall Street.¹⁴

In 2007 the losses on subprime collateral began to spike and hence the underlying collateral to the synthetic CDOs began to deteriorate. Rating agencies continued to provide very strong ratings to CDO tranches as the agencies relied too heavily on analyses provided to them by the investment banks or relatively crude assessments of the notional size of the subordination pool rather than the credit quality of the bonds themselves.

Given the superior public ratings that were assigned to certain CDO tranches, many investors came to view these tranches as near riskless. Rating agencies were greatly criticized following the Credit Crisis for reportedly not sufficiently analyzing or modeling the expected losses on the CDOs. For example, the rating agencies assumed that securitizers could create safer financial products by diversifying among many mortgage-backed securities, when these securities weren't that different to begin with and the agencies based their CDO ratings on ratings they themselves had assigned on the underlying collateral.

There were a lot of things (the credit rating agencies) did wrong. They did not consider the appropriate correlation between (and) across the categories of mortgages.¹⁵

Rating CDOs was an extremely profitable business for the agencies. One rating firm reported revenues from structured products, which included mortgage-backed securities and CDOs, that grew from $199 million in 2000, or 33% of total revenues, to $887 million in 2006, or 44% of overall corporate revenue. The overall surge in structured finance activity during the first half of the 2000s helped fuel an increase in the firm's revenues and profits, as revenues spiked from $602 million in 2000 to $2 billion in 2006 while profit margins jumped from 26% to 37%.¹⁶

According to the conclusion found by the Financial Crisis Inquiry Council, the high ratings erroneously given CDOs by credit rating agencies encouraged investors and financial institutions to purchase them and enabled the continuing securitization of nonprime mortgages, and there was a clear failure of corporate governance at certain rating agencies, which did not ensure the quality of its rating on tens of thousands of mortgage-backed securities and CDOs.

THE U.S. GOVERNMENT TAKEOVER OF THE GSEs

A government-sponsored enterprise is a financial services corporation created by the U.S. Congress. Its intended function is to enhance the flow of credit to targeted sectors of the economy and to make those segments of the capital market more efficient and transparent, and to reduce the risk to investors and other suppliers of capital. The desired effect of the GSEs is to enhance the availability and reduce the cost of credit to the targeted borrowing sectors primarily by reducing the risk of capital losses to investors: agriculture, home finance, and education.

The two best-known GSEs are the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). Fannie Mae was founded in 1938 by the Reconstruction Finance Corporation during the Great Depression to buy mortgages insured by the Federal Housing Administration (FHA). Meanwhile, in 1970 Congress chartered the creation of Freddie Mac to serve as a second GSE. Fannie and Freddie were authorized to buy “conventional”¹⁷ fixed-rate mortgages that had to conform to the GSE's underwriting standards that had limits on debt-to-income, loan size, and minimum down payments, among other criteria.

Fannie Mae and Freddie Mac's primary mission was to purchase residential mortgages from banks operating in all 50 U.S. states. As such, the GSEs did not originate mortgages but rather purchased them in the secondary mortgage market by providing ongoing liquidity to support homeownership. The GSEs purchased mortgage loans from banks, thrifts, and mortgage companies and held them in their portfolios. As individual banks across the country booked new individual mortgage loans, they sold many of these loans to the GSEs relatively quickly, freeing up capital to write more loans.

Laws enacted between 1968 and 1970 gave the GSEs the option of securitizing mortgages rather than holding all loans on their respective balance sheets. Now the GSEs could assemble a pool of mortgages and issue securities backed by them. Ginnie Mae was the first GSE to securitize mortgages, followed by Freddie Mac in 1971 and Fannie Mae in 1981. Throughout most of their histories, the GSEs' residential mortgage business and closely related RMBS securitization activities were both focused on generally low-risk fixed-rate mortgages that were subject to national underwriting standards that stipulated, among other criteria, conservative minimum down payments. Congress granted Fannie Mae and Freddie Mac certain benefits such as exemptions from state and local taxes and substantial lines of credit to support ongoing activities.

In 1995, President Bill Clinton announced an initiative to boost homeownership from 65.1% to 67.5% of U.S. families by 2000. Also in 1995, Clinton loosened housing rules by rewriting the Community Reinvestment Act,¹⁸ which put added pressure on banks to lend in low-income neighborhoods. The political drive to increase homeownership increased under the George W. Bush administration by the introduction of the Zero Down Payment Initiative,¹⁹ which in certain cases removed the minimum 3% required down payment on FHA mortgages that carried U.S. government guaranty.²⁰

In the early 2000s, there was a rapid increase in U.S. homeownership, combined with a significant increase in competition among banks, mortgage companies, and other entities for new business. Durinig this period of increased home ownership, subprime loan origination jumped from 7.6% of all mortgage origination to a peak of 23.5% between 2001-2006. This decline in credit standards occurred during the same period in which U.S. home prices soared. Between 1997 and their peak in 2006 the average home price jumped 152%, more than in any decade since the 1920s.²¹

Another contributing factor to the growing asset bubble in the residential mortgage sector was the easy credit conditions that existed in the early 2000s. For example, from 2000 to 2003 the Federal Reserve lowered the Fed Funds target rate from 6.5% to 1%, making mortgages much more accessible to millions of additional Americans.

Moving into early 2008, the U.S. economy continued to suffer, with GDP falling to an annual rate of just 0.7%, which was the worst result recorded in the United States since the 1990s. Meanwhile, the unemployment rate increased to 5% in the first quarter from 4.4% in the Spring of 2007.

Given that Fannie Mae and Freddie Mac were a key national source of liquidity in the mortgage market, the U.S. government feared that a potential failure of the GSEs would cause a systemic event. Trillions of dollars of GSE debt was owned across the globe and a tremendous amount of MBS carried guaranties from the GSEs.

On September 4, the FHFA agreed with Treasury that the GSEs needed to be placed into conservatorship,²² and on September 6 the management of of Fannie Mae and Freddie Mac received notification from the FHFA recommending that the regulator be appointed conservator of the companies.

THE TIPPING POINT: LEHMAN BROTHERS' FAILURE

Lehman Brothers Holdings Inc. (Lehman) was one of the longest running financial services firms in the United States, having been founded in 1850. During 2008, Lehman ranked as the fourth largest investment bank in the United States, ranking behind Goldman Sachs, Morgan Stanley, and Merrill Lynch and focused mainly on investment banking, equity, and fixed-income sales and trading.

Lehman was one of the largest Wall Street players in the residential real estate market, including the subprime CDO sector. In addition, the firm had a very high reliance on short-term funding (e.g., nearly $8 billion of commercial paper and nearly $200 billion of repos), which exposed it to a “run” by creditors who could quickly cease such funding, putting tremendous pressure on the firm to quickly replace billions of short-term financing. Additionally, as one of the world's biggest players in over-the-counter (OTC) derivatives, Lehman's estimated 900,000 derivatives contracts with hundreds of counterparties across the world were a cause for growing concern on the part of regulators, investors, and creditors worldwide.

On June 9, 2008, Lehman reported a second-quarter loss of $2.8 billion, its first loss since it went public in 1994. A few days later Lehman announced they would be replacing both their chief operating officer, Joe Gregory, and chief financial officer, Erin Callan. The company's share price fell to $30 per share.²³

On June 25, 2008 the results of the most recent stress tests showed that Lehman would need $15 billion more than the $54 billion in liquidity resources to survive the potential loss of all unsecured funding and certain portions of its secured borrowings.²⁴ In July, a couple of very large and important repo counterparties of Lehman, indicated they would no longer provide such funding to Lehman, which only served to fuel concerns of Lehman's stakeholders.²⁵

During the summer months of 2008, U.S. regulators had many meetings and attempted to find solutions to save Lehman from what was becoming an ever-increasing risk of failure due to the firm's tremendous real estate exposure and its vulnerable funding structure, combined with a growing loss of confidence in the firm by its most critical counterparties and liquidity providers.

Just a few of the numerous potential options that were considered by Lehman, in coordination with its regulators, included an investment in the firm by Korea Development Bank, an acquisition by Barclays Bank, the sale of Lehman's investment management division, bulk sale of real estate assets, and splitup of the firm into a “good bank”/“bad bank” structure in which its riskiest assets would get segregated into a newly created entity.

However, the most heavily debated and most controversial of all options was an outright bailout by the U.S. government. Treasury Secretary Paulson repeatedly made the case that a private sector solution was the only feasible approach and that the government was not going to provide any extraordinary credit support for Lehman, in part due to the substantial criticisms it received following the bailout of Bear Stearns.²⁶ Paulson made several attempts to coordinate an effective bailout of Lehman by its largest counterparties, which included firms such as Bank of America, Barclays, and other major banks and investment banks. One of the most significant obstacles was the refusal of the Fed to consider an interim guaranty of Lehman's debts until a potential Barclays acquisition could be approved by its shareholders and completed. The overriding concern was that should a run on Lehman by its counterparties continue during this transition period, the Fed could find itself owning an insolvent entity, greatly exposing U.S. taxpayers to losses.²⁷

During the first two weeks of September, some of Lehman's most important short-term funding counterparties began demanding significant increases in collateral to offset credit risk concerns that were reaching a critical stage, putting additional stress on the company.

On September 15, 2008, the firm filed for Chapter 11 bankruptcy protection following the massive exodus of most of its clients, drastic losses in its stock, and devaluation of assets by credit rating agencies, largely sparked by Lehman's involvement in the subprime mortgage crisis and subsequent allegations of negligence and malfeasance.²⁸ The following day, Barclays announced its agreement to purchase, subject to regulatory approval, Lehman's North American investment-banking and trading divisions along with its New York headquarters building.²⁹ The next week, Nomura Holdings announced that it would acquire Lehman Brothers' franchise in the Asia-Pacific region, including Japan, Hong Kong, and Australia,³⁰ as well as Lehman Brothers' investment banking and equities businesses in Europe and the Middle East. The deal became effective on October 13, 2008.

Lehman's bankruptcy filing is the largest in U.S. history and clearly played a major role in exacerbating the Credit Crisis. The day Lehman filed for bankruptcy, the Dow Jones Industrial Average dropped more than 500 points while approximately $700 billion in value disappeared from retirement plans, government pension funds, and other investment portfolios. For Lehman itself, the bankruptcy impacted 8,000 subsidiaries and affiliates worldwide, approximately 100,000 creditors, and its 26,000 employees worldwide.³¹ Immediately following Lehman's failure and in the years since then, there has been significant debate and in some cases criticism toward the Fed for the decision to help rescue firms like Bear Stearns, AIG, and the GSEs but not to directly intervene to avoid Lehman's collapse. The Fed has defended its role by stating, among other things, that it lacked the legal authority to provide the type of extraordinary support that would have been required to save Lehman. In testimony before the FCIC, Bernanke admitted that the considerations behind the government's decision to allow Lehman to fail were both legal and practical, stating, “We are not allowed to lend without a reasonable expectation of repayment. The loan has to be secured to the satisfaction of the Reserve Bank. Remember, this was before TARP. We had no ability to inject capital or make guarantees.”³²

AFTERMATH OF THE CREDIT CRISIS

Most historical financial crises, particularly those involving the failure of many banks, are typically followed by a prolonged economic downturn. The Credit Crisis was no exception as it plunged both the United States and Europe into significant recessions and led to historically large declines in housing prices, stock market performance, and personal household net worth.

Impact on Housing Prices: As previously discussed, many historical financial and banking crises were fueled by an unsustainable runup in real estate prices followed by a bursting of the price bubble. Table 3.1 illustrates the peak-to-trough changes in real housing prices associated with some of the larger financial crises of the past hundred-plus years. According to the S&P/Case Shiller Home Price Index, peak-to-trough decline in the quarterly index of national U.S. housing prices fell from 189.9 in 2Q 2006 to 125.7 in 1Q 2011. As devastating as this real estate crash was on the U.S. economy, 7 of the 12 worst peak-to-trough housing declines globally were worse than the decline that occurred during the Credit Crisis.

In addition to the greater than 30% decline in home prices during the Credit Crisis, homeownership rate declined from a peak of 69.2% in 2004 to 66.9% in late 2010.³³ Mortgage delinquency rates rose dramatically during this period, as evidenced by third-quarter 2010 serious delinquency rates,³⁴ such as 19.5% in Florida, 17.8% in Nevada, 10.8% in Arizona, and 10.3% in California. Note that these states were collectively referred to as the “sand states,” which were the states most negatively affected by the Credit Crisis.³⁵

Impact on Growth: A study of the average real GDP growth for advanced nations experiencing a banking crisis shows that GDP starts at about 2.5% in T minus 3 years (where “T” denotes the year of the banking crisis) and steadily falls to just under 1% in T and T plus 1. This drop is even more pronounced when analyzing five of history's most significant banking crises, in which the average GDP of the involved countries starts at approximately 4.5% in T minus 3 years and drops to a low of almost minus1% in T plus 1.³⁷ The average downturn in GDP following severe financial crises is 4.8 years.

Regarding the Credit Crisis, GDP fell at an annual rate of 4% in the third quarter of 2008 and 6.8% in the fourth quarter, representing the largest decline since 1946.³⁸ In June 2009 the United States officially emerged from the recession that had started in December 2007. Overall, in advanced economies, the median cumulative loss in output relative to its pre-crisis trend has been 33% of GDP. In the European Union, through 2013, GDP remained below its pre-crisis level and is about 13% below its pre-crisis trend.³⁹

Impact on Equity Prices: The average downturn phase of an equity market decline following a crisis is 3.4 years. Equity prices typically reach their highest level the year before the onset of a banking crisis and experience double-digit declines for two or three years as the crisis develops and occurs, but then quickly recover in a V-shaped manner reaching or exceeding the original peak within three years following the crisis. Regarding the Credit Crisis, equity prices as measured by the Dow Jones Industrial Average fell over half (–51.1%) from a peak of 14,165 on October 9, 2007, to a low of 6,926 on March 5, 2009.⁴⁰ Meanwhile, the S&P 500 Index dropped by one-third in 2008, the largest annual decline since 1974. Similarly, worldwide stock prices plunged over 40% in 2008 per the MSCI World Index stock fund.⁴¹

Impact on Unemployment: Historically, unemployment rises for an average of five years because of financial crises, with an average increase of 7%. Concerning the Credit Crisis, the recession in the United States officially began in December 2007 and the fallout on the U.S economy was dramatic. In 2008, the United States lost 3.8 million jobs, the greatest annual decline since records were first kept in 1940. By December 2009, the economy lost another 4.7 million jobs. Meanwhile, the underemployment rate, the measure of those who are actively seeking jobs, those working part-time but who prefer full-time, and those who have abandoned job searches, nearly doubled to 17.4% in October 2009 from December 2017. The amount of time it took unemployed workers to find a job skyrocketed to 25.5 weeks in June 2010 from 9.4 weeks in June 2008. The overall unemployment rate increased to 10.1% by October 2009, the highest rate since 1983 and about double the rate prior to the Credit Crisis.

COST OF GOVERNMENT BAILOUTS

The amount of funds injected by the U.S. Treasury via numerous bailout programs or directly to certain financial institutions totaled $609 billion. Table 3.2 presents the allocation of bailout funds disbursed by the U.S government to a total of 935 individual firm recipients under various bailout programs because of the Credit Crisis. Note that approximately 40% of the total funds were received by banks and other financial institutions, followed by government-sponsored entities at 31%.

Despite the massive scale of the bailout funds disbursed, as of February 2014, the U.S. Treasury had earned an estimated net profit of $12.5 billion because of outright repayments of funds by bailed-out firms ($384 billion), dividends payments received from bailed-out firms ($206 billion), interest payments ($1.8 billion), warrants ($9.5 billion), and other miscellaneous proceeds ($19.5 billion). Two of the largest recipients of TARP funding, Fannie Mae and Freddie Mac, repaid $192 billion as of 2014.

Although the sheer dollar amount of the TARP program was massive, it did not result in direct losses to U.S. taxpayers. In a similar vein, the Reconstruction Finance Corporation⁴² ultimately achieved a cumulative profit of $160 million on its capital of $500 million during the Great Depression. The FDIC, created in 1933 during the Great Depression, also contributed heavily to fighting contagion risk during the Credit Crisis. Consistent with its original mandate of providing sufficient insurance to depositors of banks to minimize the likelihood of a run, during the Credit Crisis the FDIC expanded the amount of insurance by granting unlimited insurance to transaction accounts and higher limits for other accounts.⁴³

About the regulatory failures that occurred before and during the Credit Crisis, the Financial Crisis Inquiry Commission (FCIC) pointed to a series of errors that included the mistaking of concentrated risk for diversification, the lack of a comprehensive framework for assessing systemic risk, and the failure to account for the growing asset bubble in U.S. housing prices:

We conclude collapsing mortgage-lending standards and the mortgage securitization pipeline lit and spread the flame of contagion and crisis. When housing prices fell and mortgage borrowers defaulted, the lights began to dim on Wall Street. This report catalogues the corrosion of mortgage-lending standards and the securitization pipeline that transported toxic mortgages from neighborhoods across America to investors around the globe.⁴⁵

KEY POINTS

• During the Credit Crisis of 2007–2009 the failure or distress of many large global financial institutions caused reverberations across the global financial markets and economies, leading to deep recessions in the U.S and continental Europe.
• In the couple of years preceding the start of the Credit Crisis there were several prominent public figures who either dismissed or countered concerns about an overheating U.S. economy.
• The size of the U.S. financial sector more than doubled from an average of about 4 percent of GDP in the mid-1970s to almost 8 percent of GDP by 2007.⁴⁶ Financial innovation had been rapidly on the rise during the 2000s, with securitization representing Wall Street's most popular and profitable products.
• Between 2003 and 2007, U.S. home prices rose 27% and $4 trillion of RMBS securities were created, from which Wall Street launched approximately $700 billion of mortgage-backed CDOs.
• In the early years of CDS trading, the clear majority were used as hedging tools. However, in the years leading up to the Credit Crisis more and more firms began using CDS to speculate on firm defaults rather than hedging against such events.
• Even though a growing percentage of the CDO reference collateral was below investment grade, by repackaging these securities into new CDO tranches, they could be sold to investors with ratings that usually ranged from BBB all the way up to AAA.
• Given the superior public ratings that were assigned to certain CDO tranches (e.g., AAA or AA), many investors came to view these tranches as near riskless, leading to criticism of certain rating agencies following the Credit Crisis for not sufficiently analyzing or modeling the expected losses on CDOs.
• Certain U.S. government policy actions dating back to the 1990s were aimed at increasing U.S. homeownership. In 1995 President Bill Clinton announced an initiative to boost U.S. homeownership from 65.1% to 67.5% of families by 2000. Also in 1995, Clinton loosened housing rules by rewriting the Community Reinvestment Act, which put added pressure on banks to lend in low-income neighborhoods.
• Another contributing factor to the growing asset bubble in the residential mortgage sector was the easy credit conditions that existed in the early 2000s. For example, from 2000 to 2003 the Federal Reserve lowered the Fed Funds target rate from 6.5% to 1%, making mortgages much more accessible to millions of additional Americans.
• Subprime loan origination jumped from 7.6% of all mortgage origination to a peak of 23.5% between 2001 and 2006.
• On September 4, the FHFA agreed with Treasury that the GSEs needed to be placed into conservatorship.
• Lehman was one of the most active Wall Street firms in the residential real estate sector and particularly in the risky subprime mortgage business. The firm also had an extremely large dependence on short-term financing structures to fund its daily operations (e.g., repos and commercial paper).
• Despite reporting equity capital of about $28 billion in mid-2008, many of Lehman's key counterparties lost confidence in the firm and began to change the terms of their funding arrangements with Lehman by restricting additional funding or significantly increasing the collateral Lehman had to post to continue such arrangements.
• While months of discussions and negotiations took place during the summer of 2008 between the U.S. Federal Reserve, Treasury, Lehman, and several of its largest counterparties, a government-arranged bailout or takeover of the firm could not be agreed to by any of these stakeholders.
• Just a couple of weeks after the U.S. government takeover of the GSEs, on September 15, one of Wall Street's largest and oldest investment banks, Lehman Brothers Inc., declared bankruptcy, the largest such bankruptcy in the history of the United States.
• While over 300 U.S. banking institutions ultimately failed because of the Credit Crisis, the failure of Lehman is universally viewed as the most significant firm failure during that period and is considered the event that triggered the worst of the fallout from the crisis.
• The TARP program in the United States was utilized to provide bailouts to many institutions, with the largest percentage of funds going to the U.S. GSEs in the total amount of $187 billion.
• The aftermath of the Credit Crisis was devastating in many ways. Among other impacts, it sent both the United States and Europe into deep recessions, led to >30% average decline in U.S. home prices, a similar decline in U.S. equity markets, a spike in U.S. unemployment to over 10%, and a tremendous loss in personal household net worth.