Crisis & Response: Financial Crisis

Financial Crisis The financial market turmoil that began in 2007 led to a severe global economic downturn. The causes of the crisis, the effects on global financial markets, and the spillover to the economy are examined here.
Essential Questions
What ignited the financial crisis? A rapid reversal of U.S. house prices set off a chain of events that eventually led to the global financial crisis. Housing boom Between 2000 and 2006, U.S. house prices rose dramatically, fueling a home construction boom. Easy credit Lenders made loans on ever-easier terms even to risky borrowers; those loans were sold to investors who underestimated the risk. Housing bust and mortgage meltdown As house prices started to fall, the housing boom quickly turned into a bust, bringing home construction to a halt and creating a vicious cycle that led to delinquencies. » Learn more Why did the mortgage meltdown threaten the financial system? Banks and other financial institutions faced enormous losses on mortgage loans and related investments, leading to a worldwide pullback in credit. Mortgage-related losses skyrocket The mortgage meltdown drove down the value of residential mortgage-related loans and investments held by banks and other financial institutions in the United States and abroad. Confidence erodes Financial institutions became increasingly worried about the viability of other financial institutions, which made it very difficult for those institutions to obtain short-term funding. Financial markets panic Following the failure of investment banking giant Lehman Brothers, markets for short-term funding broke down altogether, igniting global financial panic. » Learn more How did the financial crisis threaten Main Street? Massive losses caused banks to tighten lending and the stock market to crash, sending the economy into a tailspin. Credit crunch Credit became more expensive and harder to come by. Plummeting wealth The housing and stock market crashes wiped out over 25 percent of household net worth. Recession The combination of the credit crunch and plummeting wealth sent the global economy into one of the worst recessions since the 1930s. » Learn more	• • • • • • • • • • According to one measure, U.S. house prices rose about 10 percent per year on average from 2000 to 2006, well outpacing gains in income. Early this decade, securitization of riskier mortgages expanded rapidly, including subprime mortgages made to borrowers with poor credit records. Starting with subprime mortgages, more and more homeowners fell behind on their payments. Eventually, this spread to prime mortgages as well. In October 2007, shortly after the onset of the housing bust, the International Monetary Fund (IMF) estimated that losses of financial institutions related to U.S. residential mortgages would total $240 billion. By April 2009, their estimate was nearly six times larger, exceeding $1.4 trillion. Fears about the financial health of other firms led to massive disruptions in the wholesale bank lending market and rates on short-term loans rose. In the fall of 2008, two large financial institutions failed: the investment bank Lehman Brothers and the savings and loan Washington Mutual. Several others threatened to go under. Confidence in the financial sector collapsed and stock prices plummeted. Banks and investors clamped down on many types of loans by tightening standards and demanding higher interest rates - a classic credit crunch. Plummeting house prices reduced the wealth of Americans by over $7 trillion. In addition, nearly one half of stock market wealth was lost during the worst stage of the crisis. The recession had been relatively mild until the fall of 2008 when financial panic intensified, causing job losses to soar.
Policymakers' Perspectives • •
June 8, 2010 Moving Beyond the Financial Crisis Elizabeth A. Duke, Governor Board of Governors June 3, 2010 The High Cost of Exceptionally Low Rates Thomas M. Hoenig, President Federal Reserve Bank of Kansas City April 20, 2010 Lessons from the Failure of Lehman Brothers Ben S. Bernanke, Chairman Board of Governors April 7, 2010 Asset Bubbles and the Implications for Central Bank Policy William C. Dudley, President Federal Reserve Bank of New York November 9, 2009 Financial Regulation: Past and Future Daniel K. Tarullo, Governor Board of Governors October 23, 2009 International Perspective on the Crisis and Response Donald L. Kohn, Vice Chairman Board of Governors April 16, 2009 A Minsky Meltdown: Lessons for Central Bankers Janet L. Yellen, President Federal Reserve Bank of San Francisco April 6, 2009 The Panic of 2008 Kevin Warsh, Governor Board of Governors