This is the timeline of events leading up to the 2008 financial crisis.
- Back drop - The financial industry in the USA is slowly being deregulated
- The Dot Com Bubble bursts causing the early 2000's recession.
- The Fed lowers interest rates to stimulate the economy (Figure Four)
- The Fed leaves interest rates too low for too many years (Figure Four)
- People start to buy houses using adjustable rate mortgages (Figure Three)
- Driven by high demand the housing market booms for years (Figure Two)
- Banks invent securitization and create MBS's, CDO's and other credit derivatives
- Using David X. Li's model these are rated as low-risk (AAA) investments
- Demand for credit derivatives from funds and prop-trading desks soars (Figure One)
- Most hedge-funds and prop-trading desks trade credit derivatives on margin (Figure Eight)
- Demand for mortgages increases to meet demand for the credit derivatives
- Mortgage lending companies lend more money to higher-risk individuals (moral hazard)
- Fly-by-night lenders sell sub-prime NINJA loans to individuals then sell them to banks
- All of the new credit derivatives still carry low-risk ratings from ratings agencies
- Demand for credit default swaps starts to rise. Banks sell them (Figure Seven)
- Almost all banks re-insure their credit default swap exposure with AIG
- The Fed raises interest rates 17 times from 2004 through to 2006 (Figure Four)
- Payments on Adjustable Rate Mortgages start to rise and people can't afford them.
- Demand for houses starts to drop and the housing bubble loses steam (Figure Two)
- People start to default as a result of costs as well as strategically (Figure Five & Six)
- The defaults experienced far exceed the estimates from the Gaussian Copula.
- Returns in leveraged credit derivatives desks and funds start dropping.
- Ratings agencies down-grade credit derivative instruments (finally)
- Leverage positions tighten (Figure Eight) and hedge funds and banks get margin calls
- To raise capital banks and hedge-funds start selling off liquid assets
- The selling pressure drives down the market incl. assets in banks and AIG (Figure Nine)
- Lehman brothers can't raise enough capital and files for bankruptcy.
- Pay-offs on CDS's soar and banks are on the hook. They ask AIG for capital.
- AIG does not have enough capital and turns to the Federal reserve bank.
- The liquidity in the inter-bank network dries up. Liquidity crisis is in full swing.
- The Federal reserve banks turns to congress to approve the bail-out programme.
- The bail-out programme is initially rejected causing markets to fall further.
- The next day the market falls by almost 8% and continues to fall (Figure Nine)
- The bail-out plan (TARP) is approved. The Fed starts printing money for banks and AIG.
- AIG pays off it's liabilities generated from the CDS's it re-insured to the banks.
- The banks pay people who bought CDS's. John Paulson becomes a billionaire.
- By the end of 2008 the market is down ~30% YTD (Figure Nine)
- The Financial markets start to stabilize and as they say, the rest is history.