What caused the 2008 financial crisis?

The 2008 financial crisis started when American house prices stopped rising and large numbers of risky borrowers fell behind together. Their loans had been repackaged as bonds graded safe and held by firms that borrowed from one day to the next, so the losses turned into a run on the banking system in America and Britain.

Why American mortgages went bad

House prices across the United States had not fallen since the 1930s, so lenders judged a loan by the house more than by the borrower's income. On the Case-Shiller index, prices peaked in July 2006. Subprime loans, made to borrowers with weaker repayment records, were 20 per cent of new mortgages that year on one official count.

Many borrowers counted on selling at a profit or borrowing more against a rising price. Both routes closed once prices fell, which they did by 27.4 per cent on that index by February 2012. Arrears ran at double the rate seen elsewhere in California, Arizona, Nevada and Florida, where the boom had been biggest.

How bad loans reached the banks

Lenders sold their mortgages on. Thousands were pooled, turned into bonds and cut into ranked slices, with the top slice paid first and given the highest grade. The seller paid the rating agency for that grade, and 83% of the mortgage bonds Moody's graded triple-A in 2006 later lost it.

The firms holding these bonds paid for them with loans renewed every morning, using the bonds as security. Lenders then demanded far more security or stopped lending, and the holders had to sell. British banks had a different weakness. By 2008 they had lent £700 billion more than their savers had deposited and borrowed the gap a few months at a time. When that borrowing dried up in August 2007, Northern Rock ran out of money and its savers queued from 14 September.

Why Lehman Brothers mattered

Bear Stearns was rescued in March 2008 and that September the US government put Fannie Mae and Freddie Mac under its own control, so markets expected large firms to be saved. Lehman Brothers was not, and it filed for bankruptcy on 15 September 2008.

Loans did not halt the panic, since every lender still feared being last in line. Government guarantees did. On 8 October Britain announced at least £50 billion for its banks in return for ordinary shares, and the Bank of England cut its rate to 0.5 per cent by March 2009.

What the crisis left behind

British output took more than five years to regain its 2008 peak. Unemployment rose from 5.2 to 8.0 per cent, a smaller rise than in America because pay stood still and firms kept more staff. The state recovered £20.4 billion from Lloyds against the £20.3 billion it put in, but only £35 billion from NatWest, formerly the Royal Bank of Scotland, against about £45.5 billion. Banks must now hold more of their own money behind every loan.