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Created on 05.09.2018

2008 financial crisis – a review and the lessons learned

It shaped and changed the financial world over the past ten years more than any other event – the financial crisis which began in 2007 and reached a sad climax with the bankruptcy of Lehman Brothers in September 2008. What initially seemed like an event restricted to the region turned into a global economic crisis which also affected the major Swiss banks. We look back on events, the reasons behind the crisis, how it developed and the lessons that can be learned.

To comprehend how the financial crisis developed, it’s important to understand one key word – “subprime”. The financial crisis is also known as the subprime crisis and not without good reason. Subprime loans were those provided to borrowers in the USA with a poor credit standing. In other words, loans to people who would presumably have difficulty repaying them. In the case of the financial crisis, these were mortgage loans for the purchase of homes. How did these loans trigger a global crisis? You’ll find a simple explanation here.

The cause: low interest rates sparked a construction boom

The USA experienced a construction boom during the 1990s, particularly in the housing sector. This was driven by the  US central bank (Fed) which kept interest rates low to boost the economy. The low mortgage interest rates meant that increasing numbers of US citizens could afford a loan to buy their own home. This not only increased demand for real estate but also led to rising property prices. Banks bundled these mortgages into packages called collateralized debt obligations (CDO). This meant they could be traded and the mortgages they contained sold on. These packages were given quality seals by rating agencies. CDOs were generally awarded a AAA rating which is the highest available (more on ratings can be found in our article entitled “What are ratings?”.

The problem – the risk of default on repayments was underestimated

The CDOs were sold to various investors – such as hedge funds and other financial institutions – as they offered attractive returns. The demand for more CDOs constantly increased which gradually saw them spread across the entire financial system. To meet the high level of demand, the banks and brokers granted more and more mortgages to people with a poor credit standing –  subprime mortgages. The quality of the mortgage packages constantly declined as the risk of default – in other words, the risk of the borrower not being able to pay their mortgage interest – increased. However, this did not present a problem for the banks at the time as the borrower’s home could be taken in the event of insolvency and sold if necessary. Property prices had constantly climbed until then. The CDOs therefore continued to receive the top rating and were sold as a safe investment opportunity despite many of them now also containing subprime mortgages.

The crash: more and more loan defaults in the USA

Around 2005, increasing numbers of homeowners had to sell their properties because they could no longer keep up the interest payments on them due to the poor economic situation in the USA. In particular, homeowners with a poor credit standing were badly affected. The banks demanded guarantees or the repayment of the mortgage. This resulted in the market being flooded with properties. Supply outstripped demand leading to a huge slump in property prices. The financial institutions and investors who held the CDOs and the properties as the collateral behind them saw a continual decline in the value of their securities and real estate. They tried to offload the CDOs as quickly as possible. However, as they were now widespread across the entire banking system, the financial institutions could no longer get rid of their CDOs. They were left sitting on billions of dollars worth of toxic mortgages. This spelt the end of the subprime mortgage business and sparked a global financial crisis.

The direct consequences: the crisis spread to Europe

Some European banks also had large quantities of CDOs in their portfolios and feared losses. Nobody could determine the remaining value of the securities as it was not clear which type of mortgages were contained in the individual CDOs. There was also turmoil in interbank business, in other words global trading between banks. The banks no longer trusted one another and did not want to lend money – despite being dependent on this. As a result, the European Central Bank (ECB) provided the European banks with EUR 95 billion and the Fed (the US central bank) supplied the US banks with EUR 40 billion. More and more banks faced the threat of collapse due to their CDO portfolios, particularly in the USA, but also in Switzerland. In September 2007, Credit Suisse cut 150 jobs in the mortgage business, the first Swiss bank to take such a step. In October, UBS reported potential write-offs running into billions and estimated consolidated losses of as much as CHF 800 million. 

The collapse of Lehman in 2008 marked the real start of the crisis

US financial institutions were also caught up in the crisis: in March  2008, the US investment bank Bear Stearns was taken over by its competitor JP Morgan Chase and the US government saved the two government-sponsored US mortgage banks Freddie Mac and Fannie Mae. The US investment bank Lehman Brothers could not be saved. On 15 September 2008, it filed a bankruptcy application after having to carry out several write-offs running into billions. Hopes that the government would save Lehman Brothers too were dashed. Almost 25,000 employees were laid off. Whereas the subprime crisis had only concerned people with an interest in finance up to this point, the general public worldwide had now become aware of the ramifications of the crisis for the global economy. The bankruptcy of Lehman Brothers caused turmoil on stock exchanges all over the world.

Governments put rescue packages together to save banks and themselves from the crisis

While the US government saved AIG – the world’s largest insurance group – from collapse and the US savings bank Washington Mutual was acquired by its competitor JP Morgan Chase, governments in Europe also had to intervene. In Ireland, the government provided a guarantee of EUR 400 billion for the major banks as they also got into trouble due to the subprime crisis. The government of Iceland took complete control of the banks. In October 2008 – less than a month after the collapse of Lehman Brothers – seven of the largest central banks cut their key rates in a coordinated step. These institutions included the SNB, the ECB and the Fed, the US central bank. Shortly afterwards a set of measures was agreed in Switzerland to save the financial system.

Reform at the G20 summit to stabilize the financial markets

In November 2008, representatives of the G20 countries (as well as Spain and the Netherlands) met in the USA. Here they agreed a set of measures to reform and stabilize the international financial markets. Even though after this some financial institutions faced major difficulties and the European Central Bank even had to take steps to support countries, such as France, Greece and Italy, in 2011 by purchasing government bonds, the situation settled down again between the end of 2011 and spring 2012. After further turmoil in the first half of 2012, the ECB had to issue an official assurance that it would take all possible steps to save the euro before the markets stabilized again.

What’s different today compared to the start of the 2007 crisis?

The financial crisis was still not over by 2012 – it took a long list of measures and reforms from both the ECB and the US central bank to put the banking systems back on track. Today – ten years after the collapse of Lehman Brothers – the economy in the US and Europe has recovered and many regulations and laws have entered into force to reduce the risk of a recurrence of the situation in 2007. In particular, the equity ratio requirements placed on banks have been tightened and supervision of the financial system has been improved. Will this protect the global economy from another crisis? Opinions are divided. Inflated loans once again appear to pose a risk of triggering another crisis in the USA. Lending levels have risen sharply again in recent years. One reason, for example, is the issuing of  student loans which most US students have to take out to pay for university. The increasingly high level of government debt – particularly in the euro countries – together with the rapid and sharp rise in interest rates on the European capital markets may be indications of the next crisis.

The lesson is how investors can deposit their money securely

And what does the 2008 financial crisis mean for investors today? Finding secure forms of investment has become important to many investors. Even though there is no indication of a bank failure in Switzerland in the near future, there are a few pointers to bear in mind to ensure your assets are securely invested. You could invest your assets in funds, for example. Investment funds would not be included in the bank’s bankruptcy estate. You can find out more about how funds are protected in the article entitled “How your money in the investment fund is protected in the event of extreme events.” Funds also distribute your risk not across individual companies or sectors, but instead across a wide range of different securities. By opting for a funds saving plan, you protect yourself against the risk of investing at the wrong time. Further details about funds saving plans can be found in the article entitled “What is a funds saving plan actually?.” And the general principle of not investing in products that you don’t understand applies.

If you want to know exactly how to invest your money securely, read the article “Investing in times of uncertainty”.

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