The 2008 Financial Crisis

The 2008 financial crisis highlighted the importance of financial markets and the need to ensure a well-functioning financial system. In 2010, the Wall Street Reform and Consumer Protection Act, known as the Dodd-Frank Act, was enacted to overhaul financial regulation in the aftermath of the crisis. The Dodd-Frank Act contains four main elements:

  1. Consumer protection

  2. Derivatives regulation

  3. Shadow bank regulation

  4. Resolution authority over nonbank financial institutions

Increases in the complexity of financial instruments played a large role in the financial crisis of 2008, as consumers purchased assets they either didn’t understand or were not able to afford. The Consumer Financial Protection Bureau was created by the Dodd-Frank Act to protect borrowers from abusive practices that became prevalent due to the complexity of these instruments. The proliferation of derivatives was another important factor in the crisis, because derivatives, which had been designed to spread risk, worked to conceal risk prior to 2008. As a result, the new law also contains stipulations designed to make financial markets transparent so that asset risk is no longer concealed.

Shadow bank regulation and resolution authority extend government control during financial crises to cover nonbank financial institutions. The Dodd-Frank Act gives a special panel the ability to designate financial institutions that have the potential to create a banking crisis. These designated shadow banks are then subject to banklike regulation. In addition, the government now has the authority to seize control of financial institutions that require a bailout during a crisis, the way it already did with commercial banks. This power, called resolution authority, allows governments to guarantee a wide range of financial institution debts in a crisis.

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The Dodd-Frank Act created the Consumer Financial Protection Agency to protect borrowers from abusive practices that became more prevalent as financial instruments became more complex.
© B Christopher/Alamy

Going forward, financial regulation faces several challenges. First of all, the idea that a financial institution can be “too big to fail” is still prevalent and the problem of moral hazard still exists. And, while new regulation has been put in place in the United States, it is not clear how these countries. The 2008 financial crisis highlighted the global nature of financial markets and the worldwide linkages that must be acknowledged in order for regulation to be effective.

Finally, regulation that addresses what happened in 2008 may not be effective in addressing whatever financial crisis might loom in the future. World economies and world financial markets are ever changing; regulation must be dynamic and must be able to respond to the current situation, not merely the most recent crisis.

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The Day the Lights Went Out at Lehman

On Friday night, September 12, 2008, an urgent meeting was held in the New York Federal Reserve Bank’s headquarters on Wall Street. In attendance were the outgoing Bush administration’s Treasury secretary, Hank Paulson, and the then head of the New York Fed, Tim Geithner (later the Treasury secretary in the Obama administration), along with the heads of the country’s largest investment banks. Lehman Brothers was rapidly imploding, and Paulson had called the meeting in the hope of pressing the investment bankers into a deal that would, like the LTCM bailout described in Module 26, avert a messy bankruptcy.

Since the forced sale six months earlier of the nearly bankrupt investment bank Bear Stearns to a healthier bank, Lehman had been under increasing pressure. Like Bear Stearns, Lehman had invested heavily in subprime mortgages and other assets tied to real estate. And when Bear Stearns fell as its creditors began calling in its loans and other banks refused to lend to it, many wondered if Lehman would fall next.

In July 2008, Lehman reported a $2.8 billion loss for the second quarter of 2008 (the months April–June), precipitating a 54% fall in its stock price. As its share price fell, Lehman’s sources of credit began to dry up and its trading operations withered. The CEO of Lehman, Richard Fuld, began a desperate search for a healthier bank to buy shares of Lehman and provide desperately needed funding. By early September 2008, Lehman’s loss for the third quarter had risen to $3.9 billion. On September 9, J.P. Morgan Chase, a far healthier investment bank that had been Lehman’s major source of financing for its trades, demanded $5 billion in cash as extra collateral or it would freeze Lehman’s accounts and cut off its credit. Unable to come up with the cash, Lehman teetered on the edge of bankruptcy.

In the September 12 meeting, Treasury Secretary Paulson urged the investment bankers to put together a package to purchase Lehman’s bad assets. But, fearing for their own survival in an extremely turbulent market, they refused unless Paulson would give them a government guarantee on the value of Lehman’s assets. The Treasury had made the Bear Stearns sale possible by arranging a huge loan from the New York Fed to its purchaser. This time, facing a backlash from Congress over “bailing out profligate bankers,” Paulson refused to provide government help. And in the wee hours of Monday morning, September 15, 2008, Lehman went down, declaring the most expensive bankruptcy in history.

Yet, as Fuld had earlier warned Paulson, the failure of Lehman unleashed the furies. That same day, the U.S. stock market fell 504 points, triggering an increase in bank borrowing costs and a run on money market funds and financial institutions around the world. By Tuesday, Paulson agreed to an $85 billion bailout of another major corporation, the foundering AIG, at the time the world’s largest insurer. Before the markets stabilized months later, the U.S. government made $250 billion of capital infusions to bolster major U.S. banks. Whether or not Paulson made a catastrophic mistake by not acting to save Lehman is a matter likely to be debated for years to come.

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Richard Fuld, the head of Lehman, testified before a congressional panel on how the collapse of Lehman precipitated a financial panic.
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