Why the Financial System Collapsed and Has Never Recovered

What happened on August 9th, 2007 changed markets forever

When people think of the last financial crisis, they usually think of Lehman Brothers: the financial services firm, founded in 1847, that collapsed spectacularly on September 15th, 2008. Lehman was the fourth-largest investment bank in the United States, employing roughly 25,000 staff worldwide. But a week later the firm filed for bankruptcy, never to return.

Lehman, however, was not the cause of the crisis but the fall guy. Mainstream media outlets failed to cover the real reason behind the Wall Street giant’s failure. Because, as it turns out, this was more than just a few subprime loans going bad. On a seemingly quiet day more than a year earlier, a major part of the global monetary system collapsed.

It all started in the mid-2000s when a huge real estate bubble emerged in America. The Bush administration had created a significant moral hazard by promising every American the right to own a home. Once the state began guaranteeing mortgages via Fannie Mae and Freddie Mac, real estate prices soared as lending standards dropped. Anyone with poor credit, even zero income, could take out a loan.

This was, however, until late 2006 when prices leveled off. Everyone was now a speculator, believing that real estate prices could rise indefinitely. As prices started to fall, defaults skyrocketed as many homeowners were unable to afford mortgage payments on their home.

As the mortgage market deteriorated, finally, in July 2007, stress appeared in the financial system with Bear Sterns having to liquidate two of its subprime funds.

On August 7th, 2007, the Federal Reserve held its general meeting. Bill Dudley, the highest paid official of the New York Federal Reserve Bank, said, “We’ve done quite a bit of work trying to identify some of the funding questions surrounding Bear Stearns. … There is some strain, but so far it looks as though nothing is really imminent in those areas.”

But two days later, on August 9th, 2007, Dudley was proved wrong. The financial system literally broke in half.

The fragmentation of the system, however, was only visible to those monitoring the interbank markets which usually ran smoothly as financial institutions — megabanks, pension funds, hedge funds, etc.— took part in an “interest rate arbitrage”: profiting from the difference in an asset’s price between two markets. Whenever market participants saw LIBOR, the London Interbank Offered Rate, rising, they took advantage by borrowing at the lower EFF (Effective Federal Funds) rate then lending those funds at the higher LIBOR rate, making money on the spread. It was the competitive nature of markets that helped keep the EFF and the LIBOR rate together, achieving market stability.

But, on August 9th, 2007, EFF and LIBOR broke apart. Despite the Fed providing markets with ample liquidity and easing monetary conditions, still, no party was willing to take advantage of an even greater arbitrage opportunity, indicating to the Fed and market participants that the system had broken down completely.

“The world stopped on August 9[th],” said the CEO of the then-solvent U.K bank, Northern Rock, Adam Applegarth. “It’s been astonishing. Look across the full range of financial products, across the full geography of the world, the entire system has frozen.”

From that day, the Federal Reserve realized they had lost control. Anything the central bank tried that would have encouraged market participants to reverse the disconnect had failed.

As Fed officials tried to understand what was wrong within the financial system, rumors spread about how most assets inside mortgage-backed securities (MBS) had become illiquid. Investors tried to appraise what they knew was worthless. But instead of everyone just throwing in the towel, they continued to trade MBS securities and accept it as collateral.

However, once investors saw that the federal government had refused to bail out Lehman Brother’s MBS losses, this created a panic that rippled through the financial system causing its near-collapse. The EFF-LIBOR spread, once again, blew out, revealing a mass panic and a complete separation between the Federal Reserve and the offshore market.

Why the financial system bifurcated may lie offshore in the Eurodollar system: an unregulated, secretive, and exclusive market only accessible to the big players in the finance world. It’s the most important capital market in the global financial machine, the shadow banking layer, the international waters where institutions create most of the global money supply out of thin air.

From the mid-2000s up to Lehman's collapse, liquidity within the Eurodollar system grew exponentially due to the explosion of Subprime debt securitization where financial institutions packaged up millions of risky mortgages and sold them as financial products to willing investors.

On August 9th, 2007, we likely saw the “The Great Unwinding” of liquidity within the Eurodollar system that hit breaking point in late-2008. As Subprime securities had become the dominant form of collateral, when market participants realized these assets were about to go to zero, panic ensued. No one wanted to buy and everyone wanted to sell.

In a few weeks, MBS, the main funding source that allowed financial institutions to operate and make transactions worldwide, simply disappeared, leaving only “pristine collateral” in the form of U.S government bonds to make up the difference.

Fourteen years later, and mystery still surrounds “the event”. Apart from the Great Unwinding theory, we may never know what broke the mechanism that enabled the global financial machine to function correctly. As the Eurodollar system remains shrouded in secrecy, only a few insiders will know why August 9th, 2007 occurred.

But whatever it was, it has stayed with us ever since. Sadly, our economic health now relies on the Federal Reserve’s ability to prop up our liquidity-starved financial system. Each time the U.S central bank goes on vacation, like in 2016, 2018, 2019, markets start to fall apart. And even when we do see growth, money velocity still collapses, fraudulent activity keeps hitting record levels, and inequality skyrockets.

Ever since August 9th, 2007, both the global economy and the global monetary system have never reached their former glory. Instead, ever more bizarre methods of financial engineering paired with unlimited cheap money help fill in the gaps, covering holes in the financial dam, averting multiple crises such as the leverage unwind of Covid-19 and the 2019 repo market crisis.

Despite all this, however, the system remains stable. But it comes at a cost. As a broken yet stable system helps the financial elites prop up asset prices, increasing their wealth, while the real economy and its constituents endure financial repression, we’re likely not going to see a fix or a replacement anytime soon.

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Credit to Jeff Snider for images.

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Navigating the absurdity of late-stage capitalism. For more analysis, subscribe via concoda.substack.com/subscribe. Not investment advice.

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