The Great Financial Crisis

Part I: The great financial innovation and corruption

From Tuomas Malinen on Geopolitics and the Economy.

Issues discussed:

• The route to the greatest financial crash since the Great Depression, the Great Financial Crisis of 2007-08 (-2012) explained.

• Actions of authorities feeding the mania in the U.S. housing market leading up to the crisis.

• The main lesson of the run-up to the GFC: We should not trust authorities to keep our financial system safe.

Over the Holidays, I will publish a two-part series on the Great Financial Crisis (GFC) of 2007-2008. Some argue that the crisis continued till the peak of the European debt crisis in July 2012, but it’s also generally held view that the actual financial panic concentrated on the years 2007 and 2008. This series is based on two lectures on the GFC I gave at the University of Helsinki in 2011 and 2012 as a part of a lecture series on economic crises held by Professor Vesa Kanniainen, and my book draft. I can honestly say that my two lectures were the most comprehensive presentations of the crisis I had seen anywhere outside the U.S. during that time. The GFC and these two lectures also redirected my post-Doctoral research to economic crises from income inequality and economic growth I studied in my Doctoral Thesis.

The first part of this mini-series will show that we cannot trust the authorities to provide a stable financial system. Their actions were essential leading the world to the deepest financial crash since the Great Depression.

The GFC

Like all economic crises in history, the GFC, or Panic of 2008, was not born out of a void. In the heart of the crisis was an innocent financial innovation and a genius effort to manage risks in the banking system more efficiently. Like so many times before, regulators were seriously behind "the curve" and did not understand what had been created, how it affected the financial markets and what was brewing inside the global financial system, until it was too late. To make matters worse, regulators took an active role feeding the speculation during the latter parts of the mania. The GFC truly was a failure of the whole system, not just that of the banking system.

The long road to the crisis started when the regulated commercial banking sector found a way around the financial regulation and nurtured a new "shadowy" banking system. Shadow banking is a term used to describe the part of the financial sector that operates outside of, or is only loosely linked to, the traditional system of deposit taking institutions. It provides credit intermediation through different institutions, instruments and markets. Effectively, it's a deposit-like banking system for firms and institutional investors, but because it does not accept deposits in their traditional form from consumers and corporations, it mostly falls out of the banking supervision and regulative framework. This means that shadow banks can take bigger risks and operate with higher leverage than their regulated counterparts.

In the shadow banking system, non-financial firms and institutional investors earn interest on short-term (sometimes just over-night) deposited money. These "deposits" are backed by collateral in the form of bonds which, before the crisis of 2007-2008, where usually in the form of securitized loans, obtained by commercial banks from repo and commercial paper markets. Crisis erupted, because there was a run on money markets that withdrew the collateral of the short-term deposits, and because of a cataclysmic failure in risk assessments of the new opaque (securitized) financial products. When the U.S. housing market cratered, for the first time since the 1930s, losses started to mount in the securitized financial asset universe eventually breaking the shadow banks that had took part in the speculation. Their losses fell upon commercial banks that had participated on the securitization and brokerage of the shadow banks, leading to a near-collapse of the financial system. Drastic measures of authorities averted the financial collapse, but they came at a heavy price, which will a topic of the second installment. But, how the crisis came to be?

Prerequisites