The 2008 Global Financial Crisis (GFC) remains the defining event in modern financial markets. Its causes were multiple and interconnected; its consequences — for regulation, risk management, market structure, and the global economy — were permanent. Understanding the GFC is essential for any professional working in banking and capital markets.

The originate-to-distribute model and its failure

The GFC originated in the US residential mortgage market. During the early 2000s, a structural shift occurred: banks stopped holding the mortgages they originated and instead securitised them — packaging them into Residential Mortgage-Backed Securities (RMBS) and selling them to investors globally. This 'originate-to-distribute' model created a critical incentive misalignment: the originating bank no longer bore the credit risk of the mortgage, so its incentive to assess borrower creditworthiness carefully was significantly reduced.

Mortgage underwriting standards deteriorated sharply. NINJA loans ('No Income, No Job, No Assets') were originated at scale. Adjustable-rate mortgages were sold to borrowers who could only afford the initial teaser rate. The assumption embedded in every model was that US house prices would continue rising, so even weak borrowers would be able to refinance or sell if they struggled with payments.

The CDO machine and rating agency failures

RMBS securities were further re-packaged into Collateralised Debt Obligations (CDOs), then into CDO-squareds and other synthetic instruments. Through tranching, the worst-quality mortgage pools produced AAA-rated senior tranches — rated as safe as US Treasuries.

The rating agencies — Moody's, S&P, Fitch — gave AAA ratings to tranches whose underlying assets were far lower quality than the ratings implied. Their models were built on historical US mortgage default data from a period of rising house prices. The models did not account for the possibility of a national house price decline. When house prices fell — and they fell in all states simultaneously — the default correlations that ratings models assumed to be low jumped to nearly one: all the mortgages defaulted together.

The banking system's vulnerability

Investment banks held large positions in RMBS and CDOs, either because they had originated the assets and retained senior tranches (believed to be safe), or because they were trading in structured products. These positions were marked at model prices because the market for complex structured products was illiquid — actual market prices were not always observable.

When the US housing market began to deteriorate in 2006-2007, the structured product market became increasingly illiquid. In June 2007, two Bear Stearns hedge funds that were heavy holders of subprime RMBS collapsed. In August 2007, BNP Paribas froze three funds, citing inability to value assets. Wholesale funding markets — particularly the Asset-Backed Commercial Paper (ABCP) market — froze as investors refused to roll over short-term funding backed by assets whose values were uncertain.

Bear Stearns was rescued by JPMorgan Chase with Fed support in March 2008. Then, on 15 September 2008, Lehman Brothers filed for bankruptcy — the largest bankruptcy in US history. Lehman's failure caused immediate, global, systemic shock: every institution that had OTC derivatives with Lehman faced the complexity of closing out positions; money market funds that held Lehman commercial paper 'broke the buck'; interbank lending froze.

The regulatory response

The regulatory response was comprehensive: Basel III introduced minimum capital ratios, leverage ratios, and liquidity coverage ratios; EMIR mandated central clearing of standardised derivatives and bilateral margin for uncleared ones; Dodd-Frank in the US introduced the Volcker Rule limiting proprietary trading; resolution and recovery frameworks were developed requiring banks to hold 'bail-in' capital; and stress testing became a supervisory norm.