Note: this article might be updated from time to time to iclude new developments, analysis or points of view.

Origins

The roots of the credit crisis stretch back to another notable boom-and-bust: the tech bubble of the late 1990’s. When the stock market began a steep decline in 2000 and the USA slipped into recession the next year, the Federal Reserve sharply lowered interest rates to limit the economic damage. Lower interest rates make mortgage payments cheaper, and demand for homes began to rise, sending prices up. In addition, millions of homeowners took advantage of the rate drop to refinance their existing mortgages. As the industry ramped up, the quality of the mortgages went down.

Banks and other investors had devised a plethora of complex financial instruments to slice up and resell the mortgage-backed securities and to hedge against any risks — or so they thought. Default and delinquency rates began to rise in 2006, but the pace of lending did not slow.

The first shoe to drop was the collapse in June 2007 of two hedge funds owned by Bear Stearns that had invested heavily in the subprime market. In March 2008 the Federal Reserve staved off a Bear Stearns bankruptcy by assuming $30 billion in liabilities and engineering a sale to JPMorgan Chase for a price that was less than the worth of Bear’s Manhattan skyscraper.

The Spreading of the Crisis

In the fall of 2008, the credit crunch ballooned into Wall Street’s biggest crisis since the Great Depression. As hundreds of billions in mortgage-related investments went bad, mighty investment banks that once ruled high finance have crumbled or reinvented themselves as humdrum commercial banks. As the year went on, more banks found that securities they thought were safe were tainted with what came to be called toxic mortgages. At the same time, the rising number of foreclosures helped speed the fall of housing prices, and the number of prime mortgages in default began to increase.

In September 2008, the Treasury Department announced it was taking over Fannie Mae and Freddie Mac, government-sponsored entities that were linchpins of the housing market, slid sharply. Then the US government refused to step in and salvage Lehman Brothers. Lehman’s failure sent shock waves through the global banking system, as became increasingly clear in the following weeks. Merrill Lynch, sold itself to the Bank of America to avoid a similar fate. American International Group, was bailed out by the Fed in an $85 billion deal. Stocks dropped anyway, falling nearly 500 points.

The US largest insurance company and largest savings and loan both were seized by the government. The channels of credit, the arteries of the global financial system, have been constricted, cutting off crucial funds to consumers and businesses small and large. In response, the federal government adopted a $700 billion bailout plan meant to reassure the markets and get credit flowing again. But the crisis began to spread to Europe and to emerging markets, with governments scrambling to prop up banks, broaden guarantees for deposits and agree on a coordinated response.

When the bill passed, it was still unclear how effective the bailout plan would be in resolving the credit crisis, although many analysts and economists believed it would offer at least a temporary aid. Federal officials promised increased regulation of the financial industry, whose structure was vastly different than it had been just weeks before.

The first reactions were not positive. Banks in England and Europe had invested heavily in mortgage-backed securities offered by Wall Street, and England had gone through a housing boom and bust of its own. Losses from those investments and the effect of the same tightening credit spiral being felt on Wall Street began to put a growing number of European institutions in danger. Over the weekend that followed the bailout’s passage, the German government moved to guarantee all private savings accounts in the country, and bailouts were arranged for a large German lender and a major European financial company.

When stock markets in the United States, Europe and Asia continued to plunge, the world’s leading central banks took the drastic step in October 2008 of a coordinated cut in interest rates, with the Federal Reserve cutting its two main rates by half a point. As stocks declined almost 20 percent on Wall Street, European and American officials announced coordinated actions that included taking equity stakes in major banks, including $250 billion in investments in the United States. The action prompted a worldwide stock rally, with the Dow immediate rising 11 percent. But as the prospect of a severe global recession became more evident, such gains were impossible to sustain.

Oil-producing countries were hit by a sudden reversal of fortune, as the record oil prices reached over the summer were cut in half by October because of the world economic outlook. Even an agreement on a production cut by the Organization of the Petroleum Exporting Countries in October failed to stem the price decline.

In early November, the European Central Bank and the Bank of England followed with sharp reductions of their own.

Federal officials also moved to put together a plan to aid homeowners at risk of foreclosure by shouldering some losses for banks that agree to lower monthly payments. Detroit’s automakers, meanwhile, hard hit by the credit crisis, the growing economic slump and their belated transition away from big vehicles, turned to the government for aid of their own, possibly including help in engineering a merger of General Motors and Chrysler.

The leaders of 20 major countries, meanwhile, agreed to an emergency summit meeting in Washington in Nov.ember to discuss coordinated action to deal with the credit crisis. The group agreed to work more closely, but put off thornier questions until next year, in an early challenge for the Obama administration.

Deeper Problems, Dramatic Measures

In December, economists confirmed that the United States was in a recession. Unemployment rose to its highest point in more than 15 years. Trade shrank. Home prices fell farther. As inflation virtually halted, economists began to worry about deflation, the vicious cycle of lower prices, lower wages and economic contraction.

Retailers suffered one of the worst holiday seasons in 30 years as worried consumers cut back, raising the likelihood that dozens more would join stores like Sharper Image, Circuit City and Linens 'n Things in bankruptcy.

In December, the Federal Reserve entered uncharted waters of monetary policy by cutting its benchmark interest rate to nearly zero percent and declaring that it would deploy its balance sheet and essentially print money to fight the deepening recession and locked credit markets. Many economists began to worry about the world's appetite for hundreds of billions of dollars in new Treasury debt.

Other countries followed the Fed with rate cuts of their own. Britain’s central bank a wave of refinancing that nevertheless skipped many homeowners.

A New Administration

But as Mr. Obama took office, investors were just as worried as ever, as evidenced by Wall Street’s worst Inauguration Day drop ever. The fourth-quarter corporate earnings season was marked by billion-dollar losses and uncertain outlooks for 2009. The economy showed no sign of turning around. And many lawmakers and analysts began to wonder whether the first $350 billion in bailout money had any effect at all. Banks that received bailout funds sat on their money, rather than lend it out to consumers or home buyers.

And bailout recipients such as Citigroup and Bank of America were forced to step forward for additional lifelines, raising one of the most uncomfortable questions a new president has ever had to address: Would the government nationalize the American banking system?

The new Treasury secretary, reported that presidential aides will oppose tougher conditions on financial institutions, like dictating how banks would spend their rescue money, or replacing bank executives and wiping out shareholders at institutions receiving aid.

In Februry 2009, a $2 trillion rescue plan from the Treasury, private investors and the Fed that would include a public-private rescue fund, often described as a “bad bank” for holding toxic assets, eventually buying up to $1 trillion in assets. There would also be direct capital injections into banks, and would expand a program aimed at financing consumer loans. The Fed said it could broaden the plan to include both commercial and residential mortgage-backed securities.

Read more:

Financial Times multimedia indepth analysis and covering

UK Telegraph analysis