Refining the Story of the Financial Crises in Europe and the USA

Article excerpt

The financial crisis of 2007-2009 and the current economic crisis are events of historical proportions. Yet, more than three years after the global finance markets came to a screeching halt, there is still limited consensus on what caused the financial crisis.

This is to be expected, since many of the early opinions on what led to the crisis--stock market collapse, liquidity shortage, and widespread threat of bankruptcy among banks, businesses, households, and sovereigns alike--were formed before all of the data was available. As a result, many of the conventional narratives about the financial crisis contain inaccuracies or inconsistencies.

A significant amount of research has already been made about the financial crisis, so it might not seem that another primer is necessary. But the geographical distribution of the effect of the financial crisis and economic crisis is significant, extending from the USA to Europe and having bi-directional ramifications on Asia. The impact on both individual and sovereign wealth is substantial. And future investment strategy, fiscal policy, and international financial coordination will all be considered in the context of the crises.

It is, therefore, critical to fully and accurately understand the nature of the crises and their current state to ensure that the proper lessons are learned. This article aims to present a history on the causes of the financial crisis that first emerged in the U.S. in 2007. Then it will analyze the roots of the current state of the economic crisis in Europe and the U.S. It will also assess the effects of the crises on the European and American economies. A range of topics are discussed, some of which have received deeper treatment elsewhere in economic literature, but have not been pieced together to provide a coherent past and present picture of the situation. The paper will conclude with a brief comment on how this story relates to today's economic environment and the next steps that need to be taken going forward.

Definition and a Broad Chronology of the Financial Crisis

In this section, we develop a general outline of times and events that define and delineate what we mean when discussing "the financial crisis."

In August 2007, the spread between the three-month London Inter-Bank Offer Rate (Libor) and the Overnight Indexed Swap (OIS) rate spiked. (1) The Libor is primarily a measure of risk perceived by a bank when lending overnight to another bank. The OIS measures the market view of near-term risk of lending money day-today. Put simply, the Libor-OIS spread is an indicator of how the market feels about the level of risk in the system.

The spread shows that the market suddenly felt very concerned. The historical spread between the three-month Libor and OIS has been about 10 basis points (or 0.10%), but after a slow increase towards the end of July 2007, the spread hit nearly 50 basis points by August 10, 2007. By September 2007, the spread passed 90 basis points and liquidity came to a near standstill. (2) Many have identified this as the start of the financial crisis, and we agree. Figure 1 shows the Libor-OIS spread from its 2007 lull to its peak in 2008, and subsequent return to normalcy by 2009.


As we will discuss below, the reason that the Libor-OIS spread spiked was because of concerns about the subprime mortgage debt. For decades housing prices had been rising, allowing homeowners with subprime mortgages to simply sell their home if they ever became unable to make a payment. But when housing prices started to fall in 2007, the reasons of which are discussed in section 3.1, the ability to sell suddenly disappeared and very quickly a wave of mortgage defaults hit the financial system. As a result, the banks had to announce increasing high losses on their investments and assets (write-downs), with many of those losses related to toxic subprime mortgages. …