“Lack of financial planning is the root of all empty wallets”, said by the great strategist, Mac Duke. The 2008 financial crisis was the worst economic disaster since the Great Depression of 1929, and is popularly also known as the Global Financial Crisis (GFC). The crisis began in 2007 with a depreciation in the subprime mortgage market in the United States, and it developed into an international banking crisis with the collapse of the investment bank Lehman Brothers on September 15, 2008. Banks took excessive risk which helped to enhance the financial impact on a global level. To prevent a viable collapse of the world financial system, enormous bailouts of many financial institutions and other palliative monetary and fiscal policies were employed for this purpose. A global economic downturn, The Great Recession followed the crisis.
Subprime Mortgage Bubble:
A real estate bubble (housing bubble) is an increase in housing prices fueled by speculation, demand and vigorous spending to the point of collapse. Housing bubbles usually begin to form with a rise in demand, in the wake of limited supply, which takes comparatively more time to increase and replenish. Now to know about the subprime mortgage bubble, it’s implications, it’s causes, first you need to understand how it formed at the very first stage.
The origination of housing bubble (subprime mortgage bubble) was the result of another bubble, this one in the technology sector, the dotcom bubble. Now the question is how dotcom bubble formed? During the late 1990’s many new technology companies had their common stock bid up to extremely high prices in a relatively short period of time. This activity made dotcom bubble and it bursts. After the bursting of dotcom bubble the very first thing investors did was they abandoned the stock market and subsequent stock market crash and they moved their money into real estate, and it was just the starting of making of housing bubble. Now in order to combat the mild recession that followed by technology bust, U.S. Federal Reserves cut interest rates and intended to keep them down for some period.
Home prices rose, and more and more people got into the business of buying and selling houses. The housing bubble was specified by an initial rise in real estate prices due to fundamentals, just like the tech bubble. Many investors started to buying homes as speculative investments because of the continuation of phase of bull market in real estate sector.
When you make a big bubble, what happens next; it bursts. The same happened in the case of subprime bubble. After making subprime bubble in the home mortgage sector, it’s not hard to guess what would’ve happened next, it burst. The precipitating factor for the bursting of subprime bubble was when many housing mortgage debtors failed to make their regular payments, leading to a high rate of foreclosures. While the causes of the bubble are disputed, some or all of the following factors must have contributed. Low interest rates encouraged mortgage lending, Mortgage guarantees. Many of the subprime (high risk) loans were bundled and sold, finally accruing to the quasi-government agencies Fannie Mae and Freddie Mac. The U.S. Federal Government gave an implicit guarantee which created a moral hazard and gave contribution to an overabundance of risk lending. The high default rate resultant of the accumulation of these subprime mortgages led to the financial crisis of 2008 and consequential damage to the world economy.
Causes of Financial Crisis:
In 2006 when housing prices began to fall, it was the first sign which showed that the economy was in trouble. At first, realtors didn’t realize that it was serious and instead of deep thinking about it, they praised because they thought now’s the time the overheated housing market would return to a more sustainable level. Nobody questioned the fact that there were too many homeowners with questionable credit and banks was allowing people to take out loans for 100% or more of the value of their new homes. The bursting of the U.S. housing bubble was the trigger of the crisis, which peaked in 2006/2007. Thereafter adjustable rate mortgages (ARM) and increasing default rates on subprime started to rise quickly.
Easy availability of credit through large inflows of foreign funds in U.S. palliated debt-financed consumer spending and led to boom of housing construction. When banks began to give out more loans to homeowners, housing prices started to rise. Other reasons are rising real estate prices and lax lending standards, which also contributed in real estate bubble.
The primary cause of the 2008 financial crash was the deregulation in financial industry. Speculation on derivatives financed cheap, wantonly-issued mortgages was allowed and even available to those with arguable credit worthiness. The key factors which attracted a lot of people to avail home loans was rising property values and easy mortgages. All these elements slowly created the housing bubble. When the Fed increased interest rates in 2004, the resultant increased mortgaged payments squeezed home borrowers abilities to pay. This burst the bubble in 2007.
Impact on Financial Markets:
Mortgage crisis. Credit crisis. Bank collapse. Government bailout. Headlines like these continued to appeared in newspapers in the fall of 2008, an era in which more than 30% of their value was lost by the major financial markets. This period also ranks among the most horrific in U.S. financial market history. Those who lived through these events will likely never forget the turmoil.
In October 2007, the U.S. market was on peak and it was the time when the Dow Jones Industrial Average Index overreached 14000 points. The Dow Jones average’s fall of more than 50% over a period of 17 months is similar to a 54.7% fall in the Great Depression, followed by a total drop of 89% over the following 16 months. It was estimated by the International Monetary Fund that big European and US banks cannot recover more than $1 trillion on toxic assets. These losses are expected to top $2.8 trillion from 2007 to 2010. US bank losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. Record shows that in 2009 British and Eurozone banks lost only 40% while on the other hand US bank lost 60%, estimated by the International Monetary Fund.
The crisis led to the Great Recession, where housing prices dropped more than the price plunge during the Great Depression. Two years after the recession ended, unemployment was still above 9%, and that’s not including discouraged workers who had given up looking for work.
Cost of the 2008 Financial Crisis :
The timeline of the Global Financial Crisis started in March 2008, when shares of the investment bank Bear Stearns was sold off by their investors because of the high involvement of the toxic assets. Bear approached JP Morgan Chase to bail it out, but the Fed had to sweeten the deal with a $30 billion guarantee. However, the situation on Wall Street deteriorated throughout the summer of 2008-10
Congress authorized the Treasury Secretary to take over mortgage companies Fannie Mae and Freddie Mac—which cost it $187 billion at the time—and on September 16, 2008, the Fed loaned $85 billion to AIG as a bailout. In October and November, the Fed and Treasury restructured the bailout, bringing the total amount to $182 billion, and by 2012, the government made a $22.7 billion profit when the Treasury sold its last AIG shares.
If these accounts had gone bankrupt, business activities and the economy would have ground to a halt. That crisis called for massive government intervention.
The events of the fall of 2008 are a lesson in what eventually happens when rational thinking gives way to irrationality. Some legislators blame Fannie Mae and Freddie Mac for the entire crisis. The only solution they can find was to shut down the two agencies, but if they were privatized, the result would be catastrophic because as the majority of mortgages have been guaranteed by them so it would result in collapse of housing market.
Furthermore, securitization, or the bundling and reselling of loans, has spread to more than just housing. The government must step in to regulate. There were not many differences between 2008 financial crisis and 1929 stock market crash. Both had involvement in loose credit, impetuous speculations and high debt in asset market, say, the stock market in 1929 and the housing market in 2008. To prevent banks from taking on too much risk the Dodd-Frank Wall Street Reform Act was passed by the Govt. in rule, Congress and it allowed the Federal Reserves to reduce the bank size of those that became too big to fail. Meanwhile, the Global Financial Crisis, 2008 proved that banks could not regulate themselves, they need government oversight and without it like Dodd- Frank , world could have faced another global crisis.