Followed by the European Debt Crisis, the Financial Crisis of 2007-08 was one of the worst financial crisis since the Great Depression of 1929. At least it took 4 years for the economy to collapse in 1929, as opposed to the crisis of 2007-08 which merely took 18 months. Bringing in a global economic storm, it is listed in the top 5 worst crises in the history of finance, that led to a loss of approximately $2 trillion from the global economy. It is hence, aptly, well known as the Great Recession.
It primarily originated in the US as a result of the collapse of the housing market, which severely affected financial stability and destroyed the financial system across the seas. Years of downfall saw many large corporations, banks, mortgage lenders and insurance companies collapse.
The two main preconditions of the Great Recession include:
US Congress passing legislation encouraging finance for affordable housing
Rapid development in predatory financial products targeting low-income low-information homeowners belonging to racial minorities
For a better understanding, let us go through what led to the formation of the housing bubble, which laid the foundation for one of the worst financial crises experienced throughout the history of finance.
The housing market bubble of 2007-08
The seeds of the global financial crisis were essentially sown after the terrorist attack of 9/11. The US economy crashed and went into recession, as a result of which the interest rates provided by the Federal Reserve System hit the bottom rock in 2003, from 6.5% to around 1%. The low-interest rates created a stressful situation in the investor communities of fixed income who relied on treasury bills and eventually started seeking other investment avenues.
The banking and financial institutions, taking advantage of the situation, began introducing new financial scenarios which altered the US economy status, building the housing market bubble, which gradually led to the global financial crisis of 2007-08.
The concept of affordable housing was encouraged with banks and other financial institutions to start offering low-interest loans to middle-class potential homeowners who could not afford them. With mortgages flowing in the economy, lenders introduced a new financial instrument known as mortgage-backed securities or MBS.
Essentially bonds secured by real estate and home loans, these security tokens were nothing but small mortgages bundled together which were backed by credit default swaps (or CDS) that allowed the lenders to pass on the loans along with the risks associated to the financial institutions. At that time, MBS was seen as a lucrative way to diversify portfolios and earn profits at minimal risk. All of this gradually led to a widespread practice of securitization, which eventually established a strong housing market bubble.
Through the usage of MBS, the investment banks continued trying to keep the potential returns from such investments as high as possible while bringing the risks down. Notable institutions and corporations include Lehman Brothers, Goldman Sachs, Morgan Stanley, Merrill Lynch, etc. 2003-04 witnessed these investment banks start creating Collateralized Debt Obligations and made big money out of such investment transactions in the economic market. These CDOs are basically complex yet structured financial securities that are backed by a pool of similarly characterized loans and other assets and are sold to institutional investors. They are then divided into sections, ranging from AAA to CCC, depending on the credit quality of the borrower and the mortgage in hand itself.
The continued practice of issuing derivates like MBSs and CDOs in the market resulted in a massive boom in the credit and housing sectors, which attracted worldwide investors and hence, marking the end of the immediate profiting economy.
The primary reason behind the downfall was lending out loans to people who could not afford them in order to take the mortgage out of them. This process is known as subprime lending. Investment banks would at times borrow millions of dollars to buy and securitize such derivatives, which was passed onto insurance institutions including buyers in hedge funds, pension schemes, mutual funds, private equity, etc.
Mid-2006 saw many Americans defaulting on their debt repayment, as a result of which mortgage lenders began selling their houses. Soon, the market overflowed with houses sold by mortgage holders. This created an excess of supply in the housing sector, which, by the economic theories, led to a steep decline in housing prices. This left both, the buyers and the lenders of the mortgage securities in complete chaos since they borrowed huge amounts for their investments to be worth nothing. For instance, Lehman Brothers had borrowed amounts worth US $130 billion, who eventually were forced to cease their operations in 2008.
On the other side, the insurance companies had sold these securities further and were now asked to cover them. However, they did not have enough cash on them; hence; they were in distress too.
Naturally, nobody predicted this to happen and the series of events caused trouble to every player in the market. Even people who could pay for the mortgage decided not to due to the declining value of housing prices.
The stock market crash of 2007-08
Stock market bubbles don’t grow out of thin air, they have a solid base in reality. In about a span of 18 months, the S&P lost approximately 50% of its value, marking a vicious decline in the history of finance. Though, a part of the market crash was because Congress initially rejected the Emergency Economic Stabilization Act of 2008, popularly known as the bank bailout bill; it was a series of events and a solid foundation that led to the massive failure.
The stock market crash occurred on September 29, 2008, with the Dow Jones Industrial Average falling by 777.68 points in in-day trading, which is the second-highest drop recorded in history after the beginning of the pandemic.
Here is a breakdown of the events leading to the market fall:
It was in October 2007 when economists started warning about the widespread use of collateralized debt obligations and other derivatives. The beginning of 2008 saw US losing around 17000 jobs, the worst employment hit in the 2000s. In July 2008, the crisis began threatening government agencies Fannie Mae and Freddie Mac, who demanded a government bailout. With that, Lehman Brothers declared bankruptcy on September 15, 2008, which resulted in a loss of around $196 billion in money market funds. A day later, Fed announced its decision to bail out insurance giant American International Group Inc. Soon after, it was made official that the credit markets are partially frozen and the economy entered its peak panic phase. In order to restore stability, the Fed doubled its currency swaps with central banks around the globe who were forced to provide liquidity for the frozen credit markets.
Congress finally passed the bailout bill in October 2008; however; it was too late now. The economy had contracted 0.3% in the third quarter of FY2008-09 and the nation was in recession. Later in December 2008, the Fed funds rate fell to 0%, the lowest in history.
Finally, in 2009, President Obama’s economic stimulus plan instilled confidence in the market and for the most, the stock market crash was over.
Aftermath
Investors and other key players were emotionally scarred for the next four years. Fewer and more cautious investments were made, forcing global trade to collapse. The credit availability declined through the months leaving confidence in financial stability crumbling. The stock market crash witnessed many powerful corporations collapse, including Lehman Brothers, CIT Group, General Motors, etc; facing losses worth billions. Not only that, the government had to step in to bail out major banks and finance houses. From the retail and hotel industries to those working in oil and gas, everyone was deeply affected by the toll.
Most importantly, the housing bubble was deeply impacted by the situation. It saw a steep fall of more than 31.85, with evictions and closures beginning within months. Many people who took subprime loans went into default, and hence, financial houses took a big hit.
Social after-effects included unemployment which saw an all-time high and stayed more than 9% even in the following two years. For most Americans, recovery from the crisis was slow. Millions of families lost their jobs, homes, businesses, or savings, most of which fell into the trap of poverty and continued to struggle. However, the wealthy Americans had not lost as much as the ordinary citizens who still have not recovered from the massive loss.
The US market did not sufficiently recover until 2013. While some remains of the global financial crisis are still experienced by many of us, the movement spread awareness and raised questions against the system serving the ‘1% richies”, a potent issue that soon became the theme of democracy being practiced at a state and federal level. Since the movement was not sufficiently structured, there were no reforming outcomes, at least much less than what the members of the society hoped for.
REFERENCES
Amadeo, K. (n.d.). The stock market crash of 2008. The Balance. Retrieved October 31, 2022, from https://www.thebalancemoney.com/stock-market-crash-of-2008-3305535
Singh, M. (2022, September 21). The 2007–2008 financial crisis in Review. Investopedia. Retrieved October 31, 2022, from https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp
Encyclopædia Britannica, inc. (n.d.). Effects and aftermath of the crisis. Encyclopædia Britannica. Retrieved October 31, 2022, from https://www.britannica.com/event/financial-crisis-of-2007-2008/Effects-and-aftermath-of-the-crisis
ABOUT THE AUTHOR
'Ello mates! I am Vanshika Jain, a finance enthusiast! With a keen interest in the domains of finance and economics, I aspire to dive deep in the resource knowledge of the same!
I hope you like my insights on the Financial Crisis 2007-08.
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