The financial crisis of 2007–2010 has been called by leading economists the worst financial crisis since the Great Depression of the 1930s. It contributed to the failure of key businesses, declines in consumer wealth estimated in the trillions of U.S. dollars, substantial financial commitments incurred by governments, and a significant decline in economic activity. Many causes have been proposed, with varying weight assigned by experts. Both market-based and regulatory solutions have been implemented or are under consideration, while significant risks remain for the world economy over the 2010–2011 periods. Although this economic period has at times been referred to as “the Great Recession,” this same phrase has been used to refer to every recession of the several preceding decades.

The collapse of a global housing bubble, which peaked in the U.S. in 2006, caused the values of securities tied to real estate pricing to plummet thereafter, damaging financial institutions globally. Questions regarding bank solvency, declines in credit availability, and damaged investor confidence had an impact on global stock markets, where securities suffered large losses during late 2008 and early 2009. Economies worldwide slowed during this period as credit tightened and international trade declined. Critics argued that credit rating agencies and investors failed to accurately price the risk involved with mortgage-related financial products, and that governments did not adjust their regulatory practices to address 21st century financial markets. Governments and central banks responded with unprecedented fiscal stimulus, monetary policy expansion, and institutional bailouts.

Background and causes

The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006. High default rates on “subprime” and adjustable rate mortgages (ARM), began to increase quickly thereafter. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher.

Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing construction boom and encouraging debt-financed consumption. The combination of easy credit and money inflow contributed to the United States housing bubble. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load. As part of the housing and credit booms, the amount of financial agreements called mortgage-backed securities (MBS) and collateralized debt obligations (CDO), which derived their value from mortgage payments and housing prices, greatly increased. Such financial innovation enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined, major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses. Falling prices also resulted in homes worth less than the mortgage loan, providing a financial incentive to enter foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the U.S. continues to drain wealth from consumers and erodes the financial strength of banking institutions. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses are estimated in the trillions of U.S. dollars globally.

While the housing and credit bubbles built, a series of factors caused the financial system to both expand and become increasingly fragile, a process called financialization. Policymakers did not recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. Some experts believe these institutions had become as important as commercial (depository) banks in providing credit to the U.S. economy, but they were not subject to the same regulations. These institutions as well as certain regulated banks had also assumed significant debt burdens while providing the loans described above and did not have a financial cushion sufficient to absorb large loan defaults or MBS losses. These losses impacted the ability of financial institutions to lend, slowing economic activity. Concerns regarding the stability of key financial institutions drove central banks to provide funds to encourage lending and restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions and implemented economic stimulus programs, assuming significant additional financial commitments.

Impacts on financial institutions

The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF estimated that U.S. banks were about 60 percent through their losses, but British and eurozone banks only 40 percent.

One of the first victims was Northern Rock, a medium-sized British bank. The highly leveraged nature of its business led the bank to request security from the Bank of England. This in turn led to investor panic and a bank run in mid-September 2007. Calls by Liberal Democrat Shadow Chancellor Vince Cable to nationalise the institution were initially ignored; in February 2008, however, the British government (having failed to find a private sector buyer) relented, and the bank was taken into public hands. Northern Rock’s problems proved to be an early indication of the troubles that would soon befall other banks and financial institutions.

Initially the companies affected were those directly involved in home construction and mortgage lending such as Northern Rock and Countrywide Financial, as they could no longer obtain financing through the credit markets. Over 100 mortgage lenders went bankrupt during 2007 and 2008. Concerns that investment bank Bear Stearns would collapse in March 2008 resulted in its fire-sale to JP Morgan Chase. The crisis hit its peak in September and October 2008. Several major institutions either failed, were acquired under duress, or were subject to government takeover. These included Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, Washington Mutual, Wachovia, and AIG.

Global effects

A number of commentators have suggested that if the liquidity crisis continues, there could be an extended recession or worse. The continuing development of the crisis has prompted in some quarters fears of a global economic collapse although there are now many cautiously optimistic forecasters in addition to some prominent sources who remain negative. The financial crisis is likely to yield the biggest banking shakeout since the savings-and-loan meltdown. Investment bank UBS stated on October 6 that 2008 would see a clear global recession, with recovery unlikely for at least two years. Three days later UBS economists announced that the “beginning of the end” of the crisis had begun, with the world starting to make the necessary actions to fix the crisis: capital injection by governments; injection made systemically; interest rate cuts to help borrowers. The United Kingdom had started systemic injection, and the world’s central banks were now cutting interest rates. UBS emphasized the United States needed to implement systemic injection. UBS further emphasized that this fixes only the financial crisis, but that in economic terms “the worst is still to come”. UBS quantified their expected recession durations on October 16: the Eurozone’s would last two quarters, the United States’ would last three quarters, and the United Kingdom’s would last four quarters. The economic crisis in Iceland involved all three of the country’s major banks. Relative to the size of its economy, Iceland’s banking collapse is the largest suffered by any country in economic history.

By March 2009, the Arab world had lost $3 trillion due to the crisis. In April 2009, unemployment in the Arab world is said to be a ‘time bomb’. In May 2009, the United Nations reported a drop in foreign investment in Middle-Eastern economies due to a slower rise in demand for oil. In June 2009, the World Bank predicted a tough year for Arab states. In September 2009, Arab banks reported losses of nearly $4 billion since the onset of the global financial crisis.