global-financial-crisis

What Was The Global Financial Crisis? How The 2007-8 Global Financial Crisis Affected The Business World Forever

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.

Key takeaways:

  • 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. 

Related Financial Bubbles

Tulip Mania

tulip-mania
Tulip mania was a period during the 17th century where contract prices for tulip bulbs reached extremely high levels before crashing in 1637. The causes of tulip mania have perhaps been distorted over the centuries, with many assuming it was one of the first examples of a market bubble bursting. However, the proliferation of once rare tulip bulbs probably lead to them becoming less desirable. Tulip mania remains a popular term to describe markets where high prices are associated with low value or low utility items, including baseball cards, Beanie Babies, and NFTs.

South Sea Bubble

south-sea-bubble
The South Sea Bubble describes the financial collapse of the South Sea Company in 1720, which was formed to supply slaves to Spanish America and reduce Britain’s national debt. Investors saw the potential for the South Sea Company to collect interest on the loan in addition to collecting profits from its gold, silver, and slave interests. Positive sentiment was also driven by the actions of the government. Lucrative trade profits never materialized, which caused the share price to become dangerously overvalued. Instead, the South Sea Company operated more like a bank and less like a shipping business. Capital invested from waves of new investors was redistributed to older investors in an early Ponzi scheme. The share price crashed in December 1720, with many South Sea Company directors impeached or imprisoned.

Mississippi Bubble

mississippi-bubble
The Mississippi bubble occurred when a fraudulent fiat banking system was unleashed in a French economy on the verge of bankruptcy. Scottish banker John Law proposed that the French transition from gold and silver-based currency to paper currency. Law theorized that he could sell shares in the Mississippi Company to pay off French national debt. When the company secured total control of European trade and tax collection, investor speculation increased to unsustainable levels. The company share price reached its peak in January 1720 as more and more speculative investors entered the fray. Law continued to issue banknotes to fund share purchases, which inevitably caused hyperinflation. Less than twelve months later, shares in the Mississippi Company declined by 1900% and Law had to flee France in disgrace.

Stock Market Crash of 1929

stock-market-crash-of-1929
The Stock Market Crash of 1929 was a major American stock market crash in October 1929 that precipitated the beginning of the Great Depression. Black Friday, Black Monday, and Black Tuesday are terms used to describe the calamitous fall of the Dow Jones Industrial Average over three days. The index would slide further in the following years and would not recapture its pre-crash value until November 1954. The Stock Market Crash of 1929 was caused by complacency during the economic prosperity of the 1920s with many new investors buying stocks on margin. Government mismanagement and company share prices that did not reflect their true value were also contributing factors.

Japanese Lost Decade

japan-lost-decade
The Japanese asset price bubble resulted in greatly inflated real estate and stock market prices between 1986 and 1991. During the late 1980s, the Japanese economy was booming as a result of exuberance in equity markets and skyrocketing real estate prices. The Nikkei stock market index reached a peak of 38,916 on December 29, 1989. The bubble burst soon after as the Bank of Japan raised bank lending rates to try to keep inflation and speculation in check. The economy lost over $2 trillion in value over the next twelve months. The Japanese asset price bubble was primarily caused by bank deregulation and expansionary monetary policy. Japanese banks who had lost their corporate clients instead lent to riskier small and medium enterprises. The 1985 Plaza Accord trade agreement also caused a sharp appreciation in the yen, which caused massive speculation that the Bank of Japan was happy to ride for years.

Dot-com Bubble

dot-com-bubble
The dot-com bubble describes a rapid rise in technology stock equity valuations during the bull market of the late 1990s. The stock market bubble was caused by rampant speculation of internet-related companies. At the height of the dot-com bubble, instances of private investors quitting their day jobs to trade on the financial market were common. Thousands of companies held profitable IPOs despite earning no profit or even revenue in some cases. The dot-com bubble began to burst after interest rates were raised five times between 1999 and 2000. Wall Street analysts, perhaps seeing the writing on the wall, advised investors to lower their exposure to dot-com stocks. The NASDAQ peaked in March 2000 and had lost 80% of its value by October 2002.

Global Financial Crisis

global-financial-crisis
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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