The Global Financial Crisis of 2007-08 was a shock to the entire financial system of the world. It started off due to deregulation of the system in the United States of America which later affected the entire world, especially the housing and the banking sector.
After the Glass-Steagall Act of 1933 and the Commodity Futures Modernization Act were repealed, exemptions were made on the regulation of credit default swaps, this in turn led to investment in derivates through deposits. Owing to such deregulation, the banks with derivates had started indulging in hedge fund trading. In order to deal with the 2001 recession, the Federal Bank reduced the fed fund rate to 1.25% and consequently the interest rates on adjustable-rate mortgages. Such low interest rates led to a doubling of demand for subprime mortgages between 2001-07.
This helped in ending the 2001 recession. However, by 2005, such Mortgage-Backed Security (MBS) led to the creation of an asset bubble in the real estate sector. Since the demand was so high and the supply could not keep up with the demand, the price of property skyrocketed. This made people purchase the property as investment on low mortgage loans.[1]
Now, the investors wanted to make low risk, high return investments. The US housing sector was perfect for it. So, they aimed to purchase the mortgages of houses from the bank, and if an individual defaulted, they could easily sell the mortgaged house off at a higher rate. Even the insurance companies wanted their hand in this pool of revenue, so they too played a role. So, even though there was a chance of default here, the insurance companies insured the investment money of the investors through credit default swaps. Therefore, there was low risk but great returns in this investment for the investors.[2]
The banks too wanted to make new loans and additional profits. So, they agreed to sell their mortgages to investment banks, who in turn pulled them together as bundles and sold them to investors as MBS. However, people kept purchasing houses but eventually could not pay back their loan. This led to a chain of selling and reselling of houses, in turn leading to an increase in the demand for their mortgages[3].
Consequently, to keep up with the demand, the banks started giving out loans to people with low income and even a bad credit score. Even the credit rating agencies (CRA) who are authorized to give credit ratings to borrower based on which such loans are extended, started giving higher ratings to borrowers. This is primarily because the borrower pays them to provide a credit rating, and CRA had to do it to ensure a stable client base and maintain their profits. The key role in this chain was played by investment banks, CRAs, lending banks, insurers, and the Federal Reserve.[4]
Now in 2006, the Federal Bank increased the fed fund rate to 5.25%, this in turn increased the interest rate on adjustable-rate loans. As the rate kept increasing, the homeowners were unable to keep up with this hike. This created a supply surplus of houses, leading to a fall in their demand, and in turn the prices. The prices fell to the point where the value of the house was less than the outstanding loan. This burst the asset bubble of the real estate sector[5] and led to a domino effect where the entire financial system crashed.
Investors were severely affected, investment banks like the Lehman Brothers had taken a massive toll owing to this collapse. American International Group and other such insurance companies could not make good of their promise to the investors. Large sale pull-outs happened, and banks and investors stopped lending to the US. This led to immense chaos. To save whatever was left of the system, the US government provided bail outs, lowered interest rates, and lent large amounts of money to help the banks.[6]
[1] Amadeo, Kimberly. “Causes of the 2008 Global Financial Crisis.” The Balance, 2021, https://www.thebalance.com/what-caused-2008-global-financial-crisis-3306176.
[2] Ibid.
[3] Ibid.
[4] Ibid.
[5] Ibid.
[6] Ibid.
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