1. Credit Crisis: Introduction
  2. Credit Crisis: Wall Street History
  3. Credit Crisis: Historical Crises
  4. Credit Crisis: Foundations
  5. Credit Crisis: What Caused The Crisis?
  6. Credit Crisis: Bird's Eye View
  7. Credit Crisis: Government Response
  8. Credit Crisis: Market Effects
  9. Credit Crisis: Lessons Learned
  10. Credit Crisis: Conclusion

By Brian Perry

The credit crisis of 2008 includes some key events. Let's take a look at the series of events that reshaped the global financial community and forever changed the investment landscape.

The Crisis Spreads
During a four-year period prior to the start of the credit crisis, the financial markets had been relatively calm, and compensation for assuming additional risk had been minimal. However, beginning in 2007, the markets shifted to a period of unprecedented volatility. As the credit crisis unfolded, financial institutions and hedge funds began to report large losses from their subprime mortgage and securitized product holdings. Because these products are extremely difficult to value, the exact magnitude of these potential losses remained uncertain. In the face of this uncertainty, many market participants chose to avoid all risky assets, preferring instead to invest in ultra-safe Treasury bills. (To learn more, see Volatility's Impact On Market Returns.)

Once investors began to avoid risk, liquidity started to freeze up, preventing corporations and other borrowers from accessing the credit markets. As liquidity declined and asset prices fell, rumors swirled around a variety of previously robust companies. Several prominent hedge funds sustained large losses, and Countrywide Financial teetered on the brink of insolvency before Bank of America (NYSE:BAC) purchased part of the company for $2 billion in August 2007; it would eventually purchase the remainder of Countrywide in January 2008.

Following aggressive Federal Reserve actions, markets seemed calmer, but as 2007 came to a close, the CEOs of large financial firms such as Citigroup (NYSE:C) and Merrill Lynch (NYSE:MER) were forced to resign following the disclosure of massive losses on exotic bond positions. These resignations did not put a halt to financial company losses, and as rumors continued, volatility remained high and financial markets remained illiquid.

Many of the risky assets that were the cause of concern, such as structured investment vehicles (SIVs), collateralized debt obligations (CDOs), and other structured products, are extremely complicated and difficult to price. They are also rarely traded, making an accurate value difficult to determine. Market participants dislike large losses at financial firms, but even more than that they dislike not knowing what those losses might be. Many of the largest banks and brokerage firms in the world repeatedly stated that they believed they were done taking losses, only to be forced again and again to take further write downs. This inability to accurately ascertain the true extent of losses eroded confidence in the strength of many financial firms, and in the financial system as a whole.

The Crisis Deepens
During March 2008, Bear Stearns collapsed, and was purchased by JPMorgan (NYSE:JPM) in a forced sale brokered by the Federal Reserve. In the span of 72 hours, Bear Stearns went from a profitable entity to the verge of bankruptcy. This was due to a lack of liquidity and a loss of confidence that caused many counterparties to refuse to conduct business with Bear. Fearful that a Bear Stearns collapse would severely damage the entire financial system, the Fed orchestrated a purchase of Bear by JP Morgan, even going so far as to guarantee some of Bear's liabilities. (For more on government intervention in financial crises, read The Whens And Whys Of Fed Intervention.)

A potentially more serious situation began to unfold in the summer of 2008 when Fannie Mae and Freddie Mac, the two giant federal housing agencies, began experiencing larger losses in their mortgage portfolios. Fannie and Freddie were seen as vital to the recovery of the housing sector. Their debt issuance was also massive, and its widespread ownership and implied government guarantee placed an onus on the government to take action to protect bondholders, or risk a broad-based financial and economic meltdown. (For a historical background read, Fannie Mae And Freddie Mac, Boon Or Boom?)

A Perfect Storm
On September 7, 2008, the Federal Housing Finance Agency (FHFA,) in conjunction with the Treasury Department placed Fannie Mae and Freddie Mac under federal conservatorship as part of a four-part plan to strengthen the housing agencies. It was hoped that this action would restore confidence to the marketplace, but instead, the remainder of September showed an unprecedented reshaping of the financial landscape and some of the highest levels of financial market volatility on record.

Shortly after the housing agencies' situation was resolved, confidence in a number of venerable financial institutions began to evaporate. On September 15, Lehman Brothers (OTC:LEHMQ) declared bankruptcy and Merrill Lynch agreed to be purchased by Bank of America. On September 16, American International Group (AIG), once the largest insurance company in the United States, received an $85 billion emergency loan from the federal government in order to prevent the company's bankruptcy and the chaos that might have ensued in the financial system.

Losses on Lehman Brothers bonds and a nearly complete lack of liquidity began to severely impact several money market funds. Money market funds are usually considered to be among the safest investments available, which made the problems they experienced even more troubling. When the country's oldest money market fund, the Reserve Fund, declared a loss on September 17, panic took hold in the marketplace and investors became hesitant to hold any security other than U.S. Treasury bills. (For more insight, read Will Your Money Market Fund Break The Buck?)

Rumors of bankruptcy continued to swirl among a wide variety of financial firms, including such stalwarts as Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), the two largest and most prestigious investment banks on Wall Street. Doubts about their ability to survive prompted the two companies to change their regulatory status and become commercial banks on September 21. These actions marked the end of the large, stand-alone Wall Street investment bank.

On September 25, Washington Mutual (OTC:WAMUQ), the nation's largest thrift bank, was seized by the Federal Deposit Insurance Corporation (FDIC) and its assets were sold to JPMorgan in what was officially the nation's largest bank failure to date. On September 29, the banking operations of Wachovia (NYSE:WB) (at one point the nation's fourth-largest bank) were purchased by Citigroup in a deal that included the backing of the FDIC. Subsequently, Wells Fargo (NYSE:WFC) also saw value in the assets of Wachovia and wound up purchasing the company at a higher price than Citigroup had offered.

World on the Edge
As a result of these failures and takeovers of very large financial institutions, the markets demonstrated extreme turmoil. At one point, demand for Treasury bills was so great that they were actually paying negative interest as investors fled to the world's safest asset. Credit spreads (the additional compensation required for investing in risky assets) reached all-time highs and many fixed-income and short-term loan markets essentially ceased to function. Stocks plummeted, and the Dow Jones Industrial Average suffered its worst weekly loss on record, as did the Morgan Stanley Capital International Index (MSCI.) (To learn more about indexes, read Benchmark Your Returns With Indexes.)

Faced with the increasing possibility of a systemic collapse of the financial system, policymakers around the world used every tool at their disposal to navigate the crisis. In many countries, financial institutions were nationalized and global central bankers provided unprecedented levels of liquidity to the marketplace. In the U.S., the Treasury Department unveiled a $700 billion plan designed to restore liquidity to the balance sheets of banks, repair their credit standings, and reinvigorate their willingness to lend to businesses and consumers.

Together, the events leading up to the credit crisis constituted the most monumental reshaping of the financial landscape since the Great Depression; they have also posed the most severe threat to the global financial system since that time. Investors who understand these events will be better prepared for the changing investment climate they are sure to face.

Credit Crisis: Government Response
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