The Crisis on Wall Street

This post is the first in a Bipartisan Policy Center series on the 2008 financial crisis a decade later.

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The dramatic collapse of the Wall Street investment bank Lehman Brothers ten years ago proved to be a defining moment of the financial crisis. The aftermath revealed the financial system was even more fragile than many had realized. However, the trigger that would set the crisis into motion was the bursting of a housing bubble that was years in the making.

Starting in the mid-2000s, plummeting home prices resulted in a surge in mortgage borrower defaults. Many financial institutions had considerable exposure to mortgage-based debt and took heavy losses as a result, threatening the safety of the financial system. Policymakers feared the problems in the financial sector could snowball and plunge the economy into a depression if major steps were not taken to stabilize it.

The federal government responded with emergency interventions and bailouts. In March 2008, the Federal Reserve used its emergency powers to help JPMorgan Chase acquire the collapsing investment bank Bear Stearns. The crisis accelerated over the next six months as mortgage securitization giants Fannie Mae and Freddie Mac were placed into the conservatorship of the Federal Housing Finance Agency in September. Weeks later, federal regulators surprised the market by letting Lehman Brothers fail, but then bailing out AIG almost immediately after. The failure of Lehman Brothers catalyzed a run on the money market mutual fund industry. September also saw the failure of Washington Mutual, and  Bank of America’s purchase of Merrill Lynch which was teetering on the edge of bankruptcy. In the face of widespread instability and at the urging of the financial regulators, Congress authorized funds to bail out and recapitalize the financial system.

The events of the crisis were both dramatic and complex. Given the crisis’ devastating impact on the U.S. economy, from Main Street to Wall Street, it’s important to understand the key contributors to the crisis. Here we highlight four root causes of the fragility exhibited in the financial system:

• Non-bank financial firms relied too much on short-term financing without the safeguards put in place for banks to prevent bank runs. Many non-bank financial firms, including large investment banks, relied too much on short-term financing, such as repurchase agreements and commercial paper. These financial firms did not have access to federal deposit insurance or the Federal Reserve’s discount window, which made them vulnerable to the panic that ensued during the crisis, regardless of whether they were solvent. This meant a non-bank, such as Lehman Brothers, could fail almost overnight if the market lost confidence in its solvency and stopped renewing its short-term financing.
• The financial system was undercapitalized. Many financial firms had financed themselves with less equity than prudent and became insolvent (meaning they had a negative net worth) or close to insolvent during the crisis. These firms were problematic for the economy, since insolvency, or even a market perception of insolvency, made it more difficult to secure financing and make new loans that are needed to keep economic activity churning. These firms also had more incentive to delay recognizing losses, so they could convince regulators and market participants that they were still healthy, which gave the public more reason to mistrust their financial statements and made them more vulnerable in a panic.
• Policymakers did not adequately understand the systemic risks to the financial system. Regulators were focused on the health of individual financial firms but had an insufficient understanding of the health of the overall financial system. This was problematic since the actions or failure of an individual financial firm can substantially impact other financial firms, as the crisis proved. For instance, a panic can force a distressed financial firm to sell its assets in the open market at fire sale prices, which can then trigger more panic and more fire sales across the financial system in a vicious cycle.
• Regulators lacked the tools to resolve failures at systemically important financial institutions without causing systemic disruption, so they resorted to bailouts. The disruptive failure of Lehman Brothers convinced policymakers that they could not allow certain large, complex financial firms to fail without causing substantial collateral damage to the financial system and real economy. These firms were dubbed “too big to fail” and many were bailed out through emergency capital injections. While the government funds ended up being paid back, the emergency actions were still problematic (at least without later reforms). They gave firms more incentive to take reckless risks in the future, knowing the government would likely save them.

The financial fragilities of Wall Street had serious consequences for the real economy during the crisis, which policymakers later tried to address. The Bipartisan Policy Center’s Financial Regulatory Reform Initiative has evaluated these reforms and released recommendations that will be explored later in this series. In our next piece we will review the crisis of debt overhang on Main Street and its effects on the real economy.