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Financial crisis of 2007–2008

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* In 2004, the US [[Securities and Exchange Commission]] relaxed the [[net capital rule]], which enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages. The SEC has conceded that self-regulation of investment banks contributed to the crisis.<ref>{{cite news|url=https://www.nytimes.com/2008/09/27/business/27sec.html?em|title=SEC Concedes Oversight Flaws|work=The New York Times|first=Stephen|last=Labaton|date=September 27, 2008|accessdate=May 2, 2010}}</ref><ref>{{cite news|url=https://www.nytimes.com/2008/10/03/business/03sec.html?em|title=The Reckoning|work=The New York Times|first=Stephen|last=Labaton|date=October 3, 2008|accessdate=May 2, 2010}}</ref>
* Financial institutions in the [[shadow banking system]] are not subject to the same regulation as depository banks, allowing them to assume additional debt obligations relative to their financial cushion or capital base.<ref name="Krugman 2009">{{cite book|last=Krugman|first=Paul|year=2009|title=The Return of Depression Economics and the Crisis of 2008|publisher=W.W. Norton Company Limited|isbn=978-0-393-07101-6}}</ref> This was the case despite the [[Long-Term Capital Management]] debacle in 1998, where a highly leveraged shadow institution failed with systemic implications.
* Regulators and accounting standard-setters allowed depository banks such as [[Citigroup]] to move significant amounts of assets and liabilities off-balance sheet into complex legal entities called [[structured investment vehicles]], masking the weakness of the capital base of the firm or degree of [[financial leverage|leverage]] or risk taken. One news agency estimated that the top four US banks will have to return between $500&nbsp;billion and $1&nbsp;trillion to their balance sheets during 2009.<ref>{{cite news|url=https://www.bloomberg.com/apps/news?pid=20601039&sid=akv_p6LBNIdw&refer=home|title=Bloomberg-Bank Hidden Junk Menaces $1&nbsp;Trillion Purge|publisher=Bloomberg|date=March 25, 2009|accessdate=May 1, 2010|deadurl=yes|archiveurl=https://www.webcitation.org/68F8NdlMR?url=http://www.bloomberg.com/apps/news?pid=newsarchive|archivedate=June 7, 2012|df=mdy-all}}</ref> This increased uncertainty during the crisis regarding the financial position of the major banks.<ref>{{cite news|url=https://www.bloomberg.com/apps/news?pid=20601039&sid=a6dgIOAfMIrI|title=Bloomberg-Citigroup SIV Accounting Tough to Defend|publisher=Bloomberg|date=October 24, 2007|accessdate=May 1, 2010}}</ref> Off-balance sheet entities were also used by [[Enron scandal|Enron]] as part of the scandal that brought down that company in 2001.<ref>Healy, Paul M. & Palepu, Krishna G.: "The Fall of Enron" – Journal of Economics Perspectives, Volume 17, Number 2. (Spring 2003), p. 13</ref>
* As early as 1997, Federal Reserve chairman [[Alan Greenspan]] fought to keep the derivatives market unregulated.<ref>{{cite speech|title=Government regulation and derivative contracts|first=Alan|last=Greenspan|date=February 21, 1997|location=Coral Gables, FL|url=http://www.federalreserve.gov/boarddocs/speeches/199/19970221.htm|accessdate=October 22, 2009}}{{dead link|date=June 2016|bot=medic}}{{cbignore|bot=medic}}</ref> With the advice of the [[Working Group on Financial Markets|President's Working Group on Financial Markets]],<ref>{{Cite journal|first1=Lawrence|last1=Summers|author2=Alan Greenspan, Arthur Levitt, William Ranier|title=Over-the-Counter Derivatives Markets and the Commodity Exchange Act: Report of The President's Working Group on Financial Markets|date=November 1999|page=1|url=http://www.ustreas.gov/press/releases/reports/otcact.pdf|accessdate=July 20, 2009|deadurl=yes|archiveurl=https://web.archive.org/web/20101013165049/http://www.ustreas.gov/press/releases/reports/otcact.pdf|archivedate=October 13, 2010}}</ref> the US Congress and President Bill Clinton allowed the self-regulation of the [[Over-the-counter (finance)|over-the-counter]] derivatives market when they enacted the [[Commodity Futures Modernization Act of 2000]]. Derivatives such as [[credit default swaps]] (CDS) can be used to hedge or speculate against particular credit risks without necessarily owning the underlying debt instruments. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47&nbsp;trillion. Total over-the-counter (OTC) derivative [[notional value]] rose to $683&nbsp;trillion by June 2008.<ref>{{cite news|url=https://www.forbes.com/2009/05/18/geithner-derivatives-plan-opinions-contributors-figlewski.html|title=Forbes-Geithner's Plan for Derivatives|work=Forbes|date=May 18, 2009|accessdate=May 1, 2010|first1=Stephen|last1=Figlewski}}</ref> [[Warren Buffett]] famously referred to derivatives as "financial weapons of mass destruction" in early 2003.<ref>{{cite news|url=http://www.economist.com/finance/displayStory.cfm?story_id=12274112|title=The Economist-Derivatives-A Nuclear Winter?|work=The Economist|date=September 18, 2008|accessdate=May 1, 2010}}</ref><ref>{{cite news|url=http://news.bbc.co.uk/2/hi/business/2817995.stm|title=Buffett Warns on Investment 'Time Bomb'|publisher=BBC News|date=March 4, 2003|accessdate=May 1, 2010}}</ref>
 
From 2004 to 2007, the top five US investment banks each significantly increased their financial leverage (see diagram), which increased their vulnerability to a financial shock. Changes in capital requirements, intended to keep US banks competitive with their European counterparts, allowed lower ''risk weightings'' for AAA securities. The shift from first-loss [[tranches]] to AAA tranches was seen by regulators as a risk reduction that compensated the higher leverage.<ref>{{cite book|title=Unintended Consequences|author=Edward Conard|year=2012|publisher=Penguin|pages=145–155|isbn=978-1-4708-2357-3}}</ref> These five institutions reported over $4.1&nbsp;trillion in debt for fiscal year 2007, about 30% of US nominal GDP for 2007. [[Lehman Brothers]] [[bankruptcy of Lehman Brothers|went bankrupt and was liquidated]], [[Bear Stearns]] and [[Merrill Lynch]] were sold at fire-sale prices, and [[Goldman Sachs]] and [[Morgan Stanley]] became commercial banks, subjecting themselves to more stringent regulation. With the exception of Lehman, these companies required or received government support.<ref>{{cite news|url=https://www.nytimes.com/2008/10/03/business/03sec.html|title=Agency's '04 Rule Let Banks Pile Up New Debt, and Risk|work=The New York Times|first=Stephen|last=Labaton|date=October 3, 2008|accessdate=May 2, 2010}}</ref> Lehman reported that it had been in talks with Bank of America and Barclays for the company's possible sale. However, both Barclays and Bank of America ultimately declined to purchase the entire company.<ref>{{cite news|url=https://www.nytimes.com/2008/09/13/business/13rescue.html?_r=1&hp&oref=slogin|title=U.S. Gives Banks Urgent Warning to Solve Crisis|date=September 12, 2008|accessdate=January 23, 2014|work=nytimes.com|first=Eric|last=Dash}}</ref>
 
Fannie Mae and Freddie Mac, two US [[government-sponsored enterprise]]s, owned or guaranteed nearly $5&nbsp;trillion in mortgage obligations at the time they were placed into [[conservatorship]] by the US government in September 2008.<ref name="publications1">{{cite web|url=http://www.aei.org/outlook/economics/monetary-policy/the-last-trillion-dollar-commitment/|title=The Last Trillion Dollar Commitment|author=Charles W. Calomiris|publisher=American Enterprise Institute|date=September 30, 2008|accessdate=February 27, 2009}}</ref><ref>{{cite news|url=https://www.bloomberg.com/apps/news?pid=20601109&sid=adr.czwVm3ws&refer=home|title=U.S. Considers Bringing Fannie & Freddie Onto Budget|publisher=Bloomberg|date=September 11, 2008|accessdate=February 27, 2009|deadurl=yes|archiveurl=https://www.webcitation.org/68F7thwM2?url=http://www.bloomberg.com/apps/news?pid=newsarchive|archivedate=June 7, 2012|df=mdy-all}}</ref>
 
These seven entities were highly leveraged and had $9&nbsp;trillion in debt or guarantee obligations; yet they were not subject to the same regulation as depository banks.<ref name="Krugman 2009" /><ref>[https://www.nytimes.com/2010/04/02/opinion/02krugman.html NYT-Paul Krugman-Financial Reform 101 – April 2010].</ref>
For a variety of reasons, market participants did not accurately measure the risk inherent with financial innovation such as MBS and CDOs or understand its effect on the overall stability of the financial system.<ref name="Declaration of G20" /> For example, the pricing model for CDOs clearly did not reflect the level of risk they introduced into the system. Banks estimated that $450bn of CDO were sold between "late 2005 to the middle of 2007"; among the $102bn of those that had been liquidated, JPMorgan estimated that the average recovery rate for "high quality" CDOs was approximately 32&nbsp;cents on the dollar, while the recovery rate for [[mezzanine capital|mezzanine]] CDO was approximately five cents for every dollar.<ref name="TPMBLOG1">{{cite web|date=March 2, 2009|url=http://tpmcafe.talkingpointsmemo.com/talk/blogs/paulw/2009/03/the-power-of-belief.php|title=paulw's Blog &#124; Talking Points Memo &#124; The power of belief|publisher=Tpmcafe.talkingpointsmemo.com|accessdate=November 11, 2009|deadurl=yes|archiveurl=https://web.archive.org/web/20090406005046/http://tpmcafe.talkingpointsmemo.com/talk/blogs/paulw/2009/03/the-power-of-belief.php|archivedate=April 6, 2009|df=mdy-all}}</ref>
 
Another example relates to [[AIG]], which insured obligations of various financial institutions through the usage of credit default swaps. The basic CDS transaction involved AIG receiving a premium in exchange for a promise to pay money to party A in the event party B defaulted. However, AIG did not have the financial strength to support its many CDS commitments as the crisis progressed and was taken over by the government in September 2008. US taxpayers provided over $180&nbsp;billion in government support to AIG during 2008 and early 2009, through which the money flowed to various counterparties to CDS transactions, including many large global financial institutions.<ref>{{cite news|url=https://www.bloomberg.com/apps/news?pid=20601109&sid=aKKRHZsxRvWs&refer=home|title=Bloomberg-Credit Swap Disclosure Obscures True Financial Risk|publisher=Bloomberg|date=November 6, 2008|accessdate=February 27, 2009|deadurl=yes|archiveurl=https://www.webcitation.org/68F8QZzuT?url=http://www.bloomberg.com/apps/news?pid=newsarchive|archivedate=June 7, 2012|df=mdy-all}}</ref><ref>{{cite web|last=Byrnes|first=Nanette|url=http://www.businessweek.com/bwdaily/dnflash/content/mar2009/db20090316_859460.htm?chan=top+news_top+news+index+-+temp_top+story|title=Business Week-Who's Who on AIG List of Counterparties|work=BusinessWeek|date=March 17, 2009|accessdate=May 1, 2010}}</ref>
 
The [[Financial Crisis Inquiry Commission]] (FCIC) made the major government study of the crisis. It concluded in January 2011:<blockquote>The Commission concludes AIG failed and was rescued by the government primarily because its enormous sales of credit default swaps were made without putting up the initial collateral, setting aside capital reserves, or hedging its exposure – a profound failure in corporate governance, particularly its risk management practices. AIG's failure was possible because of the sweeping deregulation of over-the-counter (OTC) derivatives, including credit default swaps, which effectively eliminated federal and state regulation of these products, including capital and margin requirements that would have lessened the likelihood of AIG's failure.<ref>{{cite book|author=Phil Angelides|title=Financial Crisis Inquiry Report|url=https://books.google.com/books?id=QIKfTVrhNfMC&pg=PA352|year=2011|publisher=DIANE Publishing|page=352}}</ref><ref>{{cite book|author=Jerry M. Rosenberg|title=The Concise Encyclopedia of The Great Recession 2007–2012|url=https://books.google.com/books?id=8YSYIHuSX2oC&pg=PA244|year=2012|publisher=Scarecrow Press|page=244}}</ref><ref>{{cite book|author1=Asli Yüksel Mermod|author2=Samuel O. Idowu|title=Corporate Social Responsibility in the Global Business World|url=https://books.google.com/books?id=KVqRAAAAQBAJ&pg=PA127|year=2013|publisher=Springer|page=127}}</ref></blockquote>The limitations of a widely used financial model also were not properly understood.<ref>{{cite web|last=Regnier|first=Pat|url=http://moneyfeatures.blogs.money.cnn.com/2009/02/27/the-financial-crisis-why-did-it-happen/|title=New theories attempt to explain the financial crisis – Personal Finance blog – Money Magazine's More Money|publisher=Moneyfeatures.blogs.money.cnn.com|date=February 27, 2009|accessdate=November 11, 2009|deadurl=yes|archiveurl=https://web.archive.org/web/20090304024927/http://moneyfeatures.blogs.money.cnn.com/2009/02/27/the-financial-crisis-why-did-it-happen/|archivedate=March 4, 2009|df=mdy-all}}</ref><ref name="Felix1">{{Cite news|last=Salmon|first=Felix | publication-date = February 23, 2009|title=Recipe for Disaster: The Formula That Killed Wall Street|magazine=[[Wired.com]]|issue=17.03|url=https://www.wired.com/techbiz/it/magazine/17-03/wp_quant|accessdate=March 8, 2009}}</ref> This formula assumed that the price of CDS was correlated with and could predict the correct price of mortgage-backed securities. Because it was highly tractable, it rapidly came to be used by a huge percentage of CDO and CDS investors, issuers, and rating agencies.<ref name="Felix1" /> According to one wired.com article: {{quotation|Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of [[David X. Li|Li's]] formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril... Li's [[Gaussian copula]] formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees.<ref name="Felix1" /> }}