In 2007, the U.S. was in the midst of an economic boom. The dotcom bubble was a distant memory, unemployment had reached a decade-low of 4.4%, and sentiment among investors was high. However, what most investors didn't realize was that their rapidly rising house price and surging equity portfolio was about to hit a brick wall. 

Asset bubbles and financial crises were not new phenomena. Going back to the of the 1840s, bubbles are a period of over-exuberance in the economic prospects of a particular asset class, and 2008 was no different.

As historians recount the Great Recession of 2008 that put hundreds of thousands of people out of work and wiped trillions of dollars off global equity markets, there is more than just surging asset prices and investor greed that played a role in the demise of the global economy in 2008.

Factors of the Economic Downturn

In addition to the emotions of greed and fear, a review of the historical record shows that several components led to the economic downturn.

1. Asset/Liability Mismatch

The mismatch in the composition of balance sheets of both Bear Stearns and Lehman Brothers played a significant role in the demise of the two U.S. investment banks.

As credit tightened, a duration mismatch where the banks relied heavily on short-term funding and held long-term assets against the funding requirements arose. As the banking crisis began to unfold, these long-term assets became less liquid to a point that when they could no longer be used as funding, the two banks became insolvent.

2. Excessive Leverage

As the Great Recession began to unfold, it was evident that investors were highly leveraged; they had been borrowing large sums of money to invest in assets, essentially increasing their bets. While prevalent in financial assets, the collapse of the housing market was a direct result of leverage.

Homeowners were borrowing large sums of money to invest in the buoyant housing market, but when the crisis hit and house prices dropped, those who were leveraged became negatively geared, and the asset could no longer fund the debt. This escalated into the foreclosure of millions of homes, and the housing crisis was well underway.

3. Excessive Risk

A further component of the 2008 crisis was financial institutions taking on excessive risk. As the mortgage crisis unfolded, it was evident that the banks that had purchased mortgage-backed securities had done so with the assumption they were safe, bearing little risk. However, as credit spreads blew out and the underlying assets were re-priced, it was evident that they were anything but risk-free. 

4. Valuation

As the post-dotcom bubble optimism continued, equity prices became increasingly out of whack with their valuation. The price to earnings ratio of the S&P 500 rose above the dotcom bubble high, then ballooned above 100, over seven times its historical average. As quickly as it rose, the turnaround was just as nasty. In the second half of 2009, the P/E ratio fell from 123 to 21. 

Economic Impact of the 2008 Bubble

The fall-out of the 2008 bubble was like no other. While unemployment soared and the stock market collapsed, the crisis will forever be remembered for unconventional central bank monetary policy. 

To stave off a complete collapse of the banking sector, the Federal Reserve and other global central banks began buying up Treasuries and mortgage-backed securities to help fund the struggling banks, a process known as quantitative easing.

In turn, it suppressed interest rates and encouraged borrowing. However, this policy had unintended consequences. Firstly, asset prices soared; the U.S. equity market entered a decade-long bull run as investors flocked to equities as bonds offered little return. As individual ownership in equities fell, the inequality grew as the record stock prices benefited fewer and fewer. 

Additionally, the flood of money into the global economic system pushed global inflation below central banks' targets, and for almost a decade the world grappled with deflation. 

Preventing and Mitigating Financial Crises

The 2008 bubble was not the first, and certainly won't be the last crisis. Crises cannot be prevented or predicted. However, as explained in the book Lombard Street (2005) by Walter Bagehot, there are tools to mitigate some of the pain:

• Providing the financial system with adequate liquidity: During the 2008 credit crisis, the Federal Reserve and other global central banks repeatedly lowered interest rates and provided extraordinary levels of liquidity to the financial system.
• Establishing confidence in the safety of the banking system: This prevents consumers from rushing to the bank to withdraw their deposits. Confidence can be secured by providing government guarantees on bank deposits; in the U.S., this guarantee comes in the form of the FDIC insurance program.

The Bottom Line

As the global economy rebounded from the Great Recession, it was clear the components of the crisis were more than just a slump in economic activity and optimism. A lack of oversight from regulators saw banks' balance sheets fall structurally out of kilter, and as leverage increased, so did the risks associated with any correction. And when that correction came, those risks became a reality.