Summarizing the Global Financial Crisis of 2008

 

Introduction

The global financial crisis of 2007-08 was one of the worst financial crises since the financial crisis of the 1930s. Millions of people lost their jobs, life savings and were left to fend for themselves on the streets. A great recession followed the financial crisis which rocked the global economy and caused ripples throughout the world for years to come. Many financial institutions including several banking companies went bankrupt. Lehman Brothers were one of the biggest financial institutions of the time that was overwhelmed by the financial crisis leading to its bankruptcy in 2008.

 

What caused the Financial Crisis?

In the years immediately prior to the financial crisis, economic conditions were stable and favorable in the US and on a global scale. The housing market in the US was booming as housing prices grew at a rapid pace and no one ever suspected that the housing market could ever crash as that sector of the economy was considered relatively safer compared to the other sectors in the economy. Then, in 2006, housing prices began to fall due to the surplus of houses being developed in the US. This oversupply killed the demand for houses and the housing sector started to collapse. On top of this, the lending institutions started the practice of subprime lending just before housing prices started to fall. Subprime lending means the lenders started to give mortgage loans to borrowers who had bad credit, or those individuals who had low-paying jobs or no jobs, which in turn meant that they had a very low probability to repay their loans. The lending institutions did not care much about the risk involved in lending to such borrowers as they did not have to bear the brunt of losses if any were to arise as these lenders repackaged these mortgages into mortgage-backed securities (MBSs) and sold them to other investors. Now, mortgage-backed securities mean that lenders piled up thousands of mortgages into a single package. Investors bought up these MBSs in the hope that a few mortgages might be in default but the majority of the mortgages would be paid up in time. Even the credit rating agencies rated these MBSs AAA ratings, that is, the best of the best. This led to many financial institutions buying up these MBSs without knowing about the majority of subprime loans that were repackaged into them.

The borrowers started to default in huge numbers thereby causing massive losses to the financial institutions that bought up these MBSs in hopes of getting good profits. These institutions then trying to cope with the loss, repossessed their houses and tried to sell them but there were very less buyers wanting to buy these houses or in some cases, no buyers at all as the housing demand had reduced drastically due to the fact of oversupply of houses in the economy. Therefore, these financial institutions were left with a ton of repossessed houses with a very slight number of buyers or in some cases, not even one buyer to sell to. In essence, the housing bubble had burst but the original lenders in these transactions were left harmless as they had already insulated themselves by selling the MBSs to other institutions. Seeing some of these financial institutions facing such losses, other investors stopped buying these MBSs thereby reducing their value altogether. Thus, those investors that had already bought these MBSs came to the realization that they will not be able to sell these MBSs even as the last resort. This led to some of them filing for bankruptcy as most of these institutions had invested large amounts into these MBSs having faith in the stability of the housing sector.

 

The Legacy of Lehman Brothers

The Lehman Brothers were one such financial institution that filed for bankruptcy. This was one of the biggest investors and financial institutions of the time. They had started their operations as a simple store in the US which evolved into a cotton trading business while they shifted their base of operations from the south to New York. Over time, Lehman Brothers shifted their operations to an independent asset management company with over 28,000 employees and more than 600 billion dollars in assets[1]. Lehman Brothers were the most involved when it came to subprime lending. Therefore, by 2008, because of the bad practice of subprime lending, the firm faced massive losses for which even the U.S. Government refused to help out. Thus, Lehman Brothers, one of the biggest names in the financial sector was forced to shut down.

 

How the crisis became global

There were multiple foreign financial investors which had invested in the housing sector in the US. This included investing in the MBSs. These foreign investors, after investing in the MBSs faced massive losses and since the financial sector is interconnected, the losses caused ripples throughout the financial sector of the world. The fact that the US is a major player in the global financial market further exacerbated the global financial crisis.

 

The Aftermath of the Crisis and the Way Forward

One of the main reasons which led to the subprime lending crisis was the lack of stringent regulations to control and regulate the financial institutions and stop them from lending excessively to borrowers. This was addressed in the aftermath of the crisis when two major legislations were passed in the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), Emergency Economic Stabilization Act and the implementation of the Basel III as part of an international response by the Basel Committee on Banking Supervision (BCBS) to the crisis.

1. The Dodd-Frank Act

This legislation was one of the most important in helping the economy come out of the crisis situation. This Act, passed in the year 2010, introduced various regulations to regulate the activities of banking institutions so that these institutions do not partake in such excessive lending. This Act introduced the Consumer Financial Protection Bureau (CFPB), which monitors and safeguards the financial interests of consumers in America. This Act also introduced the Financial Stability Oversight Council (FSOC) with the specific purpose to monitor the various types of systemically important financial institutions (SIFIs) like the banking and insurance companies and ensuring that they do not become so big and influential. This is because if any of these institutions become too big, their fall, if and when they do happen will also affect the financial sector substantially. There is also one important provision of the Dodd-Frank Act called the Volcker Rule which restricts banks from partaking in speculative trading activities. This means that banks cannot participate in trading securities for profits by their own accounts. They can only trade securities when it’s pertinent to the functioning of the bank itself or when they are working on behalf of their customers.

2. Emergency Economic Stabilization Act (EESA)

The US Congress, as part of a bailout measure, passed the EESA in the year 2008 as a direct response to the global financial crisis. This Act authorized the Treasury secretary to buy up to $700 billion worth of troubled assets to restore liquidity in the financial markets.[2] Troubled Assets are those assets whose values have dropped significantly and do not have an active market where they can be sold. This Act also paved the way for the Troubled Asset Relief Program (TARP) which was an initiative made and implemented by the US government. TARP was established to get the economy and the financial system back on track. This was done by authorizing the Treasury Secretary to purchase troubled assets from any of the affected financial institutions. As seen above, TARP was essential to the implementation of the EESA.

3. Implementation of Basel III

The Basel Accords were created by the Basel Committee on Banking Supervision which is located at the Bank for International Settlements, headquartered in Basel, Switzerland. Basel accords are basically international baking regulations made to regulate financial institutions on a global scale so that it is easier for these institutions to connect and carry out their business globally.  The need to implement Basel III was felt when Basel I and II failed to regulate and avert the global financial crisis. The implementation of Basel III had begun in the year 2010 and is still being implemented to this day as amendments and changes are still being made. Basel III was implemented to strengthen the financial sector and improve upon the international banking regulations so as not to repeat a crisis of this scale. It improved the banking system by making improvements in four different parameters. These were capital, leverage, funding, and liquidity. In short, Basel III improved upon the areas where Basel II was lacking and made it safer and easier for investors to invest in the bond markets and stock markets.

 

Conclusion

The global financial crisis happened because of the greed of bankers and investors to earn greater and greater profits. They participated in the bad practice of subprime lending while also repackaging risky mortgages into mortgage-backed securities and selling them to other financial investors. The banking regulations were also lacking to contain this practice of subprime lending. This led to the crash of the housing sector which spilled over to other countries as all the financial institutions of different countries were part of these transactions and all these institutions were interconnected so the fall of even one of these institutions caused ripples in the global economy thereby causing the fall of multiple of these institutions like a domino effect. During the financial crisis, major players in the financial sector began to go bankrupt like the Lehman Brothers, Bear Sterns, etc. along with various other financial institutions. This caused a global recession and many lost their homes, jobs, and their life savings. But the world survived the crisis and the global economy was brought back on track by certain legislations and regulations made in the US and on an international scale.

 

Bibliography

1. Bankruptcy of Lehman Brothers | Description, Cause, & Facts | Britannica
2. Major Regulations Following the 2008 Financial Crisis (investopedia.com)
3. The Global Financial Crisis | Explainer | Education | RBA
4. How The Dodd-Frank Act Protects Your Money – Forbes Advisor
5. What is Basel III? (Requirements & Regulations) | Delphix | Delphix
6. Emergency Economic Stabilization Act (EESA) of 2008 Definition (investopedia.com)
7. Bankruptcy of Lehman Brothers | Description, Cause, & Facts | Britannica

 

[1] Bankruptcy of Lehman Brothers | Description, Cause, & Facts | Britannica

[2] Major Regulations Following the 2008 Financial Crisis (investopedia.com)