The 2008 Financial Crisis
Introduction
The 2008 Financial Crisis also known as the Global financial crisis was a critical economic meltdown and was seen as the second most disastrous crisis after The Great Depression in pre covid times.
It sparked The Great Recession which led to the loss of more than 2 trillion USD and cost 2.6 million jobs worldwide. Major investment banks filed for bankruptcy and the US government intervened and spent nearly 1500 billion dollars to bail them out. The unemployment rate soared to 10% in the US and it reduced to pre-crisis lows as late as 2017.
Primary Causes
The prime cause of the 2008 Financial crisis is the bursting of the US Housing Bubble and the subsequent devaluation of homes. The US Federal Reserve slashed down home loan rates to 1% to enable its citizens to get loans at low-interest rates. Lenders sold these Mortgages to Large investment Banks like Bear Sterns. Investment banks then bundled these loans into ‘low risk’ Collateralized Debt Obligations and Mortgage-backed Securities and sold them to investors. It was risk-free to Banks and Hedge Funds as even if borrowers defaulted, Banks can acquire homes, whose values were ever-increasing. Due to an increase in demand for loans from Investment Banks, lenders lifted major loan regulations and lent even to borrowers with low credit scores and unstable jobs. These loans, considered ‘sub-prime’ dominated credit in the early 2000s.
Housing interest rates increased steadily to 5.5% in 2006 and many sub-prime borrowers defaulted. US homeownership market reached its saturation level in 2006 and prices began to fall. Sub-prime Borrowers were concerned that their homes cost less than their loan and are stuck with a costly mortgage which they can’t pay. As more and more subprime borrowers defaulted, lenders started filing for bankruptcy one after the other. By August 2007 major international banks either froze or approached governments for a bailout.
Markets froze and banks were not ready to lend to each other. By mid-2008, a full-fledged recession swept the US and regional banks were decimated. The US government tried to save some of the largest players of the economy like American International Group, Bear Stearns, Fannie Mae, and Freddie Mac. Despite these efforts, Lehman Brothers, a 85 years old investment bank with 600 million in funds collapsed and marked the largest bankruptcy in world history. By March 2008, Bear Stearns went under and JP Morgan Chase acquired it at a shockingly low price of 2 dollars per share.
The US government announced a 1500 billion USD relief program to bring the economy back on track. It bought out ‘troubled assets’ held by banks and bailed out major banks from its ruins. Even after great relief programs, unemployment doubled from 5% to 10% in 2 years and 3.8 million had to leave their underpriced homes to repossession.
Aftermath
There was widespread public resentment and taxpayers felt that their money is used for the bailout of banks which first-hand caused the crisis. The falling of the US economy sparked a domino effect and pulled the world economy with it. Economies of Western Europe, the Baltic States, Mexico, and other OECD countries fell off a cliff. The effect on South Asia and China was relatively less. Automobile companies lacked the finances to run their supply chains and subsequently Automobile sales took a hit.
In the aftermath of the crisis, Dodd-Frank Wall Street Reform and Consumer Protection Act was passed to prevent lax lending, predatory practices of banks and established greater control over activities of Global Exchanges.
Stock market bubbles happen quite regularly and when they burst, the effect is limited to few investors. But 2008 Housing Bubble grew bigger than it should due to lax lending, apathetic rating agencies, and unchecked pursuit for profits. When it burst, it destroyed the livelihood of many who were not directly related to the housing bubble. Nevertheless, it took a long time for the economy to recover and for investors to gain confidence in the market.
