We all are aware of the financial crisis or the recession which took place in the year 2008.

The Global Financial Crisis of 2008, is considered to be the worst financial disaster since the Great Depression of the 1930s.

It all began in the year 2007 with a breakdown of US subprime mortgage. And it grew into a full-blown international banking crisis with the collapse of the big investment bank, Lehman Brothers on September 15, 2008.

Origin of Crisis

The major and immediate cause which triggered the financial crisis was the bursting of the US housing bubble, which peaked in FY 2006-2007

But it all started after the terrorist attacks of 9/11. The US economy went into a recession as result in the Federal Reserve System (Fed) lowered its rate to 1%.

As 1% is a very low interest rate, investors of fixed income that used to buy US treasury bills were not satisfied by the rates they received and started looking for other investment avenues.

Investment banks in the US were aware of this situation and they started implementing some of their financial wizards on mortgages.

Investment banks in the US started with securitizing mortgages into Mortgage-Backed Security (MBS) which is a form of asset-backed securities.

An MBS is basically a collection of different mortgages that are geographically dispersed in order to increase diversification and thereby decrease risk.

Through MBS, Investment banks try keeping potential returns from such investments as high as possible while simultaneously decreasing risk.

So, starting from FY 2003-4 banks like Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, and Lehman brothers, started packaging MBS and creating what is known as Collateralized Debt Obligation (CDO).

These CDOs are then divided into sections starting from AAA to CCC depending on the credit quality of the borrower and also the underlying mortgages themselves.

Investment banks were making big money out of these transactions in the US market.

Also, as the credit and housing market booms in the US, the number of new financial agreements or instruments like MBS and CDO, which derived their value from mortgage payments and housing prices, greatly increased.

Such financial innovation enabled institutions and investors around the globe to invest in the US housing market.

The Crisis Unfolds

But the problem arises when almost all US citizens who could potentially take out a mortgage already did and so banks had to do something about it.

And because the financial industry generally is mainly composed commercial banks on one side and insurance companies on the other side, many insurance companies got into the game (especially American International Group (AIG)) by issuing Credit Default Swaps (CDS) which is basically insurance on those CDOs.

Both commercial and investment banks knew that if someone were to default on their mortgage, the mortgage lender could take his/her house and sell it out.

So, starting from FY 2004–05 commercial banks starting offering some families with extremely poor credit scores the ability to take a mortgage and the thinking of people in the US were like if the banks’ experts are willing to lend me money, then they must be able to afford it.

This is known as Subprime lending.

It means lending money (as loans) to people who may find it difficult to maintain the repayment schedule, sometimes reflecting setbacks, such as divorce, unemployment, medical emergencies, etc.

So, the entire cycle around housing in the US was like this

  1. Commercial banks would lend insolvent families money to take out a mortgage.
  2. They would then securitize them and create MBS.
  3. Investment banks would borrow millions sometimes billions to buy this MBS.
  4. They would then package MBS to create a CDO.
  5. Buyers, such as Hedge funds, Mutual Funds, Pension Funds, Sovereign wealth funds, Institutional investors, private equity and Insurance companies, would borrow money to buy those CDOs and then resell it to the next investor in the market.

Starting from mid of 2006, many Americans started defaulting on their debt. As a result, a lot of the mortgage lenders started selling their houses.

At first, it was not a problem as instead of owning security you would own a house, and who doesn’t like owning a house right?

After a while, as more American families started defaulting on their mortgages, many of the mortgage holders started flooding the market with houses.

Hence, creating more supply then there is demand and so housing prices plummeted sharply in the US market.

Both buyers and sellers of CDOs had no idea what to do because they borrowed billions of dollars and in the case of Lehman brothers around US $130 billion and at this point their investments were worth nothing.

Due to those huge losses insurance companies who sold those CDS, were now asked to cover but since they did not have enough cash, they were in trouble too.

This is why the federal government bailed out AIG for US $180 billion dollars.

There was also another problem many of the mathematical models used by investment banks to assess the level of risk for each investment looked at mortgages in the particular geographical areas, but never included the possibility of a downturn in national housing or the prospect that millions of borrowers would default on their mortgages.

Thus, naturally many investment banks were not ready for such a thing to happen.

When the crisis started hitting the market, you could see many financial services companies had gigantic obligations while simultaneously running huge losses.

Adding to that, many Americans who could actually afford to pay their mortgages intentionally stopped paying it.

The reason was that many Americans took mortgages to buy second houses and as the economy dipped into the recession, they decided it was no longer a necessary investment. It didn’t make sense to pay a mortgage on US $300,000 loan when the house was worth US $100,000 only.

Cost of Crisis

The US government-initiated TARP a 700-Billion-dollar plan to bail out major financial services companies in the US financial market.

For example

1- Citigroup received US $25 billion

2- JP Moran chase US $25 billion

3- Wells Fargo US $25 billion

4- Bank of America US $15 billion (it acquired Merrill Lynch which received US $10 billion from the US government)

5- Morgan Stanley US $10 billion

6- Goldman Sachs US $10 billion

Apart from these, many more commercial and investment banks and other financial institutions in US, received additional capital from US treasury and external investors to cover up the gigantic losses that accumulated later on.

In the final months of 2008, the US lost nearly two million jobs.

The unemployment rate shot up to 7.2% in December 2008 from its recent low of 4.4% in March 2007, and it was almost certain to continue rising into 2009.

Economic output in the US shrank by 0.5% in the 3rd quarter of 2008. 

World-wide effects

Virtually no country in the world, developing or industrial, has escaped the impact of the widening financial crisis in the US.

It became evident in August 2007 that the financial market could not solve the US subprime crisis on its own and the problems spread beyond the US’s borders.

The inter-banking market froze completely, largely due to prevailing fear of the unknown amidst banks around the globe.

The Northern Rock, a British bank, had to approach the Bank of England for emergency funding due to a liquidity crunch.

By that time, central banks and governments around the world had started coming together to prevent further financial disaster.

By the end of 2008, all of the major economies around the world were in a recession or struggling to stay out of one.

World bank forecast an increase in global economic output of just 0.9% in 2009, the most tepid growth rate since records became available in 1970.

Forecast after forecast, by many renowned institutions, showed very bad global economic growth for at least 2009.

Measured by its impact on global economic output, the recession that had engulfed the world by the end of 2008 figured to be sharper than any other since the Great Depression.

Disclaimer: the views expressed here are of the author and do not reflect those of Groww.