The global financial crisis (GFC) refers to a period of extreme stress in global financial markets and banking systems between 2007 and 2009, which changed the financial system culminating in the Dodd-Frank Wall Street Reform and Consumer Protection Act. The seeds of the global financial crisis can be traced back to the 1970s, with the Community development Act leading to the creation of a massive derivative market based on real estate assets (subprime). This coupled with easy liquidity, and speculation has led to financial turmoil compared to the 1929 stock market crash.
Understanding the global financial crisis
The global financial crisis resulted from a sequence of events culminating in the near-total collapse of the banking system.
Some analysts suggest the origins of the global financial crisis can be traced back to the 1970s with the introduction of the Community Development Act. The act, which created a market for subprime mortgages, forced banks to loosen their lending criteria for lower-income borrowers. Industry deregulation in the 1980s almost removed the barriers for lenders to limit mortgage interest rates. Two decades later, the industry was booming with the deregulation allowing lenders to charge up to 60% interest on mortgages.
In the years leading up to the crisis, mortgage lenders developed many new products with opaque and predatory terms. A two-sided mortgage market began to emerge, where borrowers from minority groups were served by subprime lenders and higher-income borrowers were served by conventional lending institutions.
Subprime mortgages were often based on what the borrower claimed they earned. In other words, there was no requirement for them to prove their income. Lenders did not care if borrowers defaulted on their loans because they made their money upfront in the form of closing costs and brokerage fees. If the borrower did default, the lender had already made thousands of dollars on the deal. Many choose to simply sell their loans to Wall Street, effectively kicking the can down the street.
Between 1994 and 2005, the subprime mortgage market grew from $35 billion to $665 billion. As the industry grew, so too did the abusive and predatory lending practices. Industry experts and advocates called for a regulatory response to an emerging crisis, as mass property foreclosures affected cities including Philadelphia, Atlanta, and New York.
The global financial crisis reaches a climax
The amount of subprime mortgage debt continued to increase during the early 2000s when the Federal Reserve Board cut interest rates to avoid a recession. Loose and predatory lending practices combined with cheap money caused a housing boom which created mass speculation and a real estate bubble.
Meanwhile, the banks that had bought secondary subprime mortgages bundled them with prime mortgages. This meant there was no way for investors to properly understand the risks of subprime products.
When the subprime market collapsed, one-fifth of homes in the United States were purchased with subprime loans. Subprime borrowers began to default on loans that were worth more than the value of their homes, which simply accelerated real estate price declines.
On September 29, 2008, the House of Representatives rejected a move to create a $700 billion fund to acquire toxic mortgages. The Dow Jones Industrial Average, NASDAQ, and S&P 500 all suffered historical one-day losses.
With no market for the toxic debt of subprime mortgages, the subsequent cascade of subprime lender failures created liquidity contagion that reached the upper tiers of the banking system. Major investment banks including Bear Stearns and Lehman Brothers collapsed under the weight of their exposure to subprime loans, despite their “too big to fail” status. A further 450 smaller banks followed suit over the next five years.
Sensing that its failure would bring down the entire financial system, the government poured more than $180 billion into American International Group (AIG). The Bank of America also received bailout money, including $100 billion in guarantees to help it acquire failing financial companies and absorb their losses.
For borrowers, interest rates were lowered to almost zero after 2008. Two years later, massive financial reform was introduced by President Obama in the Dodd-Frank Wall Street Reform and Consumer Protection Act.
- The global financial crisis (GFC) refers to a period of extreme stress in global financial markets and banking systems between 2007 and 2009.
- The global financial crisis was precipitated by changes to legislation in the 1970s. The changes created the subprime mortgage industry and forced banks to loosen their lending criteria for lower-income borrowers.
- When the subprime market collapsed in 2008, one-fifth of homes in the United States had been purchased with subprime loans. Bear Stearns and Lehman Brothers collapsed because of their excessive exposure to toxic debt, while consumers were left with mortgages far exceeding the value of their homes. In the aftermath of the GFC, interest rates were reduced to near zero and there was sweeping financial reform.
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