The 2008 financial crisis: housing, Lehman, TARP and the 57% fall

The 2008 financial crisis was the worst US banking crisis since the 1930s. A fall in house prices exposed trillions of dollars of risky mortgage debt held, often with heavy borrowing, by banks and investment firms around the world. In September 2008 the crisis turned into a panic: Lehman Brothers failed, the insurer AIG needed a government rescue, and a money-market fund lost money for ordinary savers. The S&P 500 fell 56.8% from its October 2007 record to its March 2009 low, and the US economy went through its deepest recession since the Second World War.

This article explains how housing became a banking crisis, walks through the key weeks of 2008, describes the government's response from TARP to near-zero interest rates, and shows the whole bear market on SPY's real monthly bars. It is an educational history, not a view on any investment.

How housing became a banking crisis

The housing boom

US house prices rose fast from the late 1990s to 2006. Low interest rates after the The dot-com bubble: the 1995–2002 boom and the 78% Nasdaq fall helped, but the bigger change was in lending. Lenders offered mortgages to borrowers with weak credit, the "subprime" market, and loans with low teaser rates, little documentation or no down payment. Many were made on the assumption that prices would keep rising, so a borrower who could not pay could sell or refinance.

Securitization and leverage

Few of those loans stayed with the lender. They were bundled into mortgage-backed securities, sliced into layers by risk, and sold to investors worldwide; some layers were bundled again into more complex securities. Credit-rating agencies gave many of the top layers the highest ratings. Banks, investment banks and their off-balance-sheet vehicles held large amounts of these securities, often financed with short-term borrowing that had to be renewed every day or week. Some investment banks had more than $30 of assets for each dollar of capital. With that much leverage, a small fall in asset values can wipe out a firm's equity.

The turn

National home prices peaked in 2006 and began to fall. Subprime borrowers whose payments reset higher started to default, and the securities built on their loans lost value. Because nobody knew exactly which firms held the worst of them, lenders began to pull back from everyone. In August 2007, a large French bank froze several funds it could not value, and interbank lending rates jumped. The Fed began cutting rates and lending more to banks.

The crisis year, 2008

March. Bear Stearns, a major investment bank, ran out of funding in days and was sold to JPMorgan Chase with Federal Reserve support.

September 7. The government placed Fannie Mae and Freddie Mac, the giant mortgage companies, into conservatorship.

September 15. Lehman Brothers, after failing to find a buyer, filed for the largest bankruptcy in US history, with more than $600 billion of assets. That same weekend Merrill Lynch agreed to sell itself to Bank of America.

September 16. The Fed lent $85 billion to the insurer AIG, which had sold protection on mortgage securities through credit default swaps. The same day the Reserve Primary Fund, a money-market fund holding Lehman debt, "broke the buck," valuing its shares below $1. Investors rushed out of money funds, and the Treasury guaranteed them days later.

September 29. The House of Representatives voted down the first rescue bill. The Dow fell 777.68 points (6.98%), its largest point drop to that date.

October 3. Congress passed and the President signed the Emergency Economic Stabilization Act, authorizing up to $700 billion for the Troubled Asset Relief Program (TARP). Within weeks the Treasury used it to inject capital directly into banks, starting with nine of the largest.

The stock market kept falling through the end of the year and into early 2009, as the damage moved from banks to the wider economy.

The market decline on real data

On SPY's monthly closes, the S&P 500 ETF went from $154.65 at the end of October 2007 to $73.93 at the end of February 2009, a fall of 52.2%. The low of the month of March 2009 was $67.10. Daily index closes show the deeper figure, because a monthly close skips the worst days: the S&P 500 itself fell 56.8% from 1,565.15 to 676.53.

The decline came in two stages. From late 2007 to the summer of 2008 it looked like an ordinary bear market, with a rally after Bear Stearns. From September 2008 to March 2009, after Lehman, it became a crash: the S&P 500 lost nearly half its value in about six months, and daily moves of 5% or more in either direction were common. The VIX reached record levels in late 2008 (see Volatility and the VIX: historical vs implied volatility explained).

Financial stocks fared worst. Several of the largest US banks lost the great majority of their market value, and shareholders of Lehman, Bear Stearns, Fannie Mae, Freddie Mac and others lost almost everything.

The policy response

The response was larger and faster than in the 1930s, and it came on several fronts.

• The Federal Reserve cut its target for the federal funds rate to a range of 0 to 0.25% on December 16, 2008, and created emergency lending programs for banks, securities dealers, money-market funds and the commercial-paper market. In November 2008 it announced large purchases of mortgage-backed securities, expanded in March 2009 to include Treasury bonds; this became known as quantitative easing.
• The Treasury, through TARP, bought preferred stock in hundreds of banks, supported AIG, GM and Chrysler; separately, it guaranteed money-market funds through its Exchange Stabilization Fund.
• The FDIC raised deposit insurance to $250,000 per depositor and guaranteed new bank debt.
• Stress tests of the 19 largest banks, published in May 2009, told markets how much capital each needed and helped restore trust in their balance sheets.
• Congress passed a fiscal stimulus in February 2009 and, in July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act, which raised capital requirements, created regular stress tests and the Consumer Financial Protection Bureau, and moved much derivatives trading onto regulated platforms.

The stock market bottomed on March 9, 2009, before the economy did. The recession ended in June 2009 by NBER dating, but unemployment kept rising until it peaked at 10.0% in October 2009, and it took years to return to pre-crisis levels.

The recovery

From the March 2009 low the S&P 500 began one of its longest bull markets. It regained its October 2007 closing record on March 28, 2013, about five and a half years after the peak and four years after the low. SPY's first monthly close above its October 2007 close came the same month. Counting dividends, the wait was shorter.

Many individual stocks never recovered. Investors who sold near the bottom, or who were forced to sell because they had borrowed against their portfolios, did not share in the rebound. The crisis was a clear demonstration of how margin and other borrowing can turn a temporary price fall into a permanent loss.

Lessons for investors

• Leverage is where crises live. Highly borrowed firms and households were the ones forced to sell. The same was true in 1929.
• Diversification within stocks has limits in a panic. Most stocks fell together. High-quality government bonds rose in value in late 2008 and cushioned balanced portfolios, which is the main argument for Asset allocation: how stock, bond and cash mixes have behaved across asset classes.
• "Safe" can carry hidden risk. Highly rated mortgage securities and a money-market fund were supposed to be safe. Understand what an investment actually holds.
• Markets turn before the news does. The bottom came in March 2009, with unemployment still rising for seven more months. Waiting for good economic news meant missing much of the rebound.

How Finabase helps

The SPY monthly chart shows the whole 2007–2009 bear market and recovery on the same bars as the figure above, and you can switch to weekly or daily views for recent years. The XLF symbol page covers the financial-sector ETF, the part of the market at the center of the crisis, and the comparison view puts SPY, XLF and long Treasuries side by side. The indices page tracks the major benchmarks today.

Frequently asked questions

How much did the stock market fall in 2008?

The S&P 500 fell 38.5% in calendar 2008 on a price basis. The full bear market, from the October 9, 2007 record to the March 9, 2009 low, was a 56.8% decline.

What caused the 2008 financial crisis?

A housing boom built on risky mortgage lending ended in falling prices and defaults. The losses hit banks and investment firms that held mortgage securities with heavy borrowing and depended on short-term funding, and the resulting runs turned it into a global banking crisis.

What was TARP?

The Troubled Asset Relief Program, created by law on October 3, 2008, authorized the Treasury to spend up to $700 billion to stabilize the financial system. Most of it was used to buy preferred shares in banks and to support AIG and the auto industry.

How long did it take the stock market to recover from 2008?

The S&P 500 set a new closing record on March 28, 2013, about five and a half years after its October 2007 peak and four years after its March 2009 low, on a price basis.

Why did Lehman Brothers fail?

Lehman held large, highly leveraged positions in real estate and mortgage securities and relied on short-term funding. When lenders lost confidence, it could not find a buyer or government support and filed for bankruptcy on September 15, 2008.

Summary

The 2008 crisis grew from loose mortgage lending, securities built on those loans, and financial firms that held them with heavy borrowing and fragile short-term funding. Falling home prices started the losses, and Lehman Brothers' failure in September 2008 turned them into a panic. The S&P 500 fell 56.8% from October 2007 to March 2009. TARP, near-zero rates, quantitative easing and bank stress tests stabilized the system, the market bottomed months before the economy, and the S&P 500 regained its peak in March 2013.