A financial crisis occurs when a sudden, widespread disruption threatens the solvency of banks and other financial institutions. The 2007–08 global financial crisis was triggered by the prospect of substantial losses on mortgage loans made to subprime borrowers and securitised into complex, opaque, and volatile asset-backed securities (ABS). As these toxic assets were transferred from lenders to investors in the secondary market, investment firms, insurance companies, and even central banks collapsed and required bailouts.
The financial crisis was exacerbated by excessive leverage among households, businesses, and financial firms. This was partly the result of lower down payments on residential mortgages, the increased use of exotic mortgage instruments and home equity lines of credit, and declining credit standards by lenders. As a result, many homeowners were “underwater” — they owed more on their mortgages than their homes were worth.
Another factor was the buildup of risk in too-big-to-fail firms, including Fannie Mae and Freddie Mac, which were in danger of failing due to large exposures to subprime mortgages. Excessive risk-taking in too-big-to-fail institutions increases the probability of a financial crisis and makes the consequences of a crisis worse when it does occur.
Finally, the financial crisis was exacerbated by a series of failures in regulation and supervision. In particular, regulators failed to recognise the extent of subprime lending and mortgage securitisation; and they did not respond adequately to the crisis once it erupted. This included the Federal Reserve’s inability to stem the flow of toxic assets; and key policy makers’ lack of a full understanding of the financial system they oversaw.