08 June 2023
4 min read
The financial downfall of 2007 – 2008, also known as the subprime mortgage crisis 2008, is considered the worst economic downfall since the Great Depression of the 1930s.
The great financial crisis began in 2007 in the subprime mortgage market in the United States and soon developed into a full-blown international banking downfall with the collapse of the investment bank Lehman Brothers on September 15, 2008.
Parameters That Led to the Financial Crisis of 2008
We saw the first sign of the financial collapse in 2006 when housing prices started to fall a bit.
During the period leading to this economic setback, the banks in the USA had started providing loans to people of questionable credit (therefore, the name sub-prime meant the borrowers were not prime or considered creditworthy).
These banks also provided people loans up to 100% value of the houses they bought.
The government also pushed this credit because the median GDP in the USA was not growing in the last two decades.
Also, home loan interest rates had nearly reached zero during this time. Therefore, owning a house was considered an American dream which was thought to fuel the economic activity in the country by policymakers.
Further, it was exaggerated by the Gramm-Rudman Act, which allowed banks to trade in profitable derivatives that were eventually sold to investors.
These securities, popularly known as Mortgage Backed Securities (MBS), were backed by home loans as collaterals.
The MBS became so popular that all institutional investors worldwide, such as hedge funds, mutual funds and even pension funds, started to purchase these securities.
Pension funds considered these to be safe as they had enjoyed an AAA credit rating, and at the same time, these were insured by credit default swaps (CDS).
American International Group (AIG) sold these swaps during this time.
However, when the housing prices started to correct, these bought derivatives also started losing value.
Banks became cautious at this juncture and knew they would have to bear the brunt.
Credits in the markets froze as these banks were reluctant to lend to each other during such times simply because they did not want to absorb mortgages that were worthless as collateral.
Finally, the London Interbank Offered Rate (LIBOR) rose substantially. This led to panic in the markets throughout.
You may want to know 2008 Market Crash - The Global Financial Crisis
The Fall of Lehman Brothers
Lehman Brothers, one of the largest investment banks in the USA, collapsed on September 15, 2008, as they had too many toxic assets in their books. (Bear Stearns, one of the other biggest investment banks, was saved from bankruptcy earlier as JP Morgan Chase acquired it at $2 per share from the highs of double digits. The Federal Reserve also facilitated this deal).
The crisis occurred despite the Federal Reserve and Treasury Department's efforts to prevent it. This is when the housing price was corrected by more than 30% in the United States.
Massive bailouts of financial institutions and other monetary and fiscal policies were employed to prevent a possible collapse of the world economic system.
Nonetheless, this financial distress was followed by a global economic downturn known as the great recession.
Will the World Witness Another Financial Downfall?
Change in Policies
With tariff wars worldwide, we can witness different rules and policies for other countries in one of the most critical sectors, i.e. financial firms.
For example, the European regulators are trying to ensure that there is more stress testing their banks, while in the US, the Trump administration is trying to de-regulate and loosen the Dodd–Frank Act to enforce stricter regulation following the 2008 crisis.
Risk of Non-banking Institutions
Non-bank mortgage lending has increased manifolds over the past decade, with these lenders providing bank-like services without taking deposits.
This is exacerbated by the rise of so-called shadow banking, representing around 13% of the global financial system, with a large percentage allocated to China.
This industry is also increasing in India, supported by government initiatives backing this sector and given the high amount of NPAs in banks.
Are Things the Same as 2008? Can There Be Another Recession?
Though there appear to be few cracks in the world economy for various reasons mentioned above, today's world stands firmer than in 2008.
Unlike then, banks today are required to hold more capital. Therefore, we can say that they are less leveraged and have a more robust monetary position.
Secondly, we can also note that banks now hold less in trading assets, and the risk is substantially limited.
Final Stance
Overall, the system is much more financially solid, and the provisions can be handled more stably in case of failure.
The Financial Crisis of 2008 was a rare phenomenon, and financial systems have improved.
To wrap it up, though the world might witness financial problems in the coming years, probably because the recession is part and parcel of an economic cycle, the great financial crisis of 2008 was a phenomenon in itself and is most likely not going to occur again.
Happy Investing!
Disclaimer: This blog is solely for educational purposes. The securities/investments quoted here are not recommendatory.
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