The financial crisis of 2007–2008 was a severe contraction of liquidity in global financial markets that caused the failure (or near failure) of many investment and commercial banks, mortgage lenders, savings and loan associations, and insurance companies; drove the economy into its worst slump since the Great Depression of 1929–1939; and prompted a massive transfer of wealth from private citizens to the government. While the precise causes of the crisis are the subject of intense debate, most economists agree that a combination of factors played a role. These include the deregulation of over-the-counter derivatives, including credit default swaps; high delinquency and default rates among subprime borrowers; the collapse of the housing market; and a failure by credit rating agencies to correctly price risk.
The crisis also highlighted how fragile the financial system is, and how dangerous it can be if not properly governed and monitored. Consequently, the major policy responses of the 2009 Recovery Act, bank bailouts, Federal Reserve initiatives, and more aimed to stabilize the financial system, support the economy, and bolster confidence.
The most essential first step was to flood the financial system with liquidity, throwing a lifeline first to banks and then to money-market funds, commercial paper issuers, broker-dealers, and insurance firms. It took a while for the markets to rebound and for confidence to return, but the economic catastrophe that would have ensued without this intervention probably never materialized. The Dodd-Frank law now includes a clearly defined process for handling “too big to fail” institutions, and other measures should increase the capital that banks must hold in order to reduce their vulnerability to runs.