Case study: The 2008 Financial Crisis explained
The 2008 Financial Crisis explained, this piece becomes ever more important in today’s time (that is, 2020) when the world is all over again going through a crisis. Although there is a stark difference in the reasons of the causes of both – the recession of today and that of 2008. We must understand the effects are similar. That is, people will lose their jobs, consumption will drop, economies and small businesses will collapse.
Given these times, the government needs to act swiftly. Although, we’re somewhere in June currently and the unlock is in place, things are radically changing around the globe and will continue to do so in the coming year.
Anyway, let’s jump straight into the case, that is.
Also called the US housing recession, the 2008 financial crisis has been one of the worse economic situations the world had ever seen(Great depression still tops the list), and all this before 2020 happened. Whenever there has been a downfall in the US, all the other countries’ economies has have suffered along equally or more.
Do you know why?
Because almost everything around the world is traded in terms of dollars be it Oil or any other commodity. This means the dollar indirectly controls everything that goes around the World. So, if the value of the dollar goes up or down even by a little bit, currencies around the world suffer.
The entire fall is a little tricky to understand unless you have knowledge of some terms of finance, like collateral, loans, etc. But let us attempt to simplify this by the way of an example. Shall we?
Here we go…
Let us say there is a family who wants to buy a house in the US. They go to a broker, who offers them a house on a loan. All the formalities and paperwork is carried out by the broker. On agreement of both the parties, the broker then approaches a commercial bank for the loan amount.
Here, the bank asks for a security/mortgage against the loan, which will be provided by the purchasing family. Just like when you borrow some money from a friend in exchange for something. Anyway, now, the commercial bank is in the possession of mortgage papers of the family. This bank can sell these mortgage securities to third parties such as Investment banks. It is similar to saying: hey, these papers have a value of say $20 when you return this to us we will pay you $20 + $1 amount – for now, give us the money, will you? Here the bank is the party giving the paper and these investment banks are giving them money in return. They will give the papers when they get their money and interest back.
Now, here’s what an investment bank is: It is a financial institution that offers very high returns among their services. All the prime layer parties such as companies and high-income group people invest in such institutions. In the name of securities, what is given to these people by investment banks are CDOs (Collateral Debt Obligation- explained in the following notes). These CDOs were back then insured by the government and credit rating agencies were telling investors that these mortgage-backed securities were safe investments giving these securities AAA ratings. Thus people were willingly investing in huge amounts.
Do you see what happened here? Broker -> Commercial banks -> Investment banks -> Investors… these papers were passed on 4 times! everyone expecting some amount of interest on returning these papers!
…anyway let’s continue…
Now, since these CDOs are made up of mortgage papers of various loan takers, investment banks started demanding for more such security bonds from commercial banks. Commercial banks asked the brokers to find more families who needed loans. And thus began the sub-prime lending (refer following notes). They started predatory lending practices without verifying paying capability of the families.
You see the above cycle of 4 parties? this became a famous cycle! People started giving loans and credit agencies labelled these papers to be good (AA bonds). This basically means that these parties who took loans are capable of paying them back. Now the problem was, they were not capable of paying anything back – and as it turned out all the ratings were a lie!
And thus, the bubble busted when these sub-prime families stopped paying their loans. Since families were unable to repay, commercial banks started seizing their houses. Eventually, a lot of houses came under the control of banks and became available in the market, which led to the lowering of value of these houses. This all led to the US housing crisis as all the loan takers became NPAs (Non-performing assets) for the banks.
Remember all those dudes who were expecting handsome interest on their investment, save the investors? all of them suffered. Anyway, below are the effects of this entire negligence.
- Investment banks like Lehman brothers became bankrupt and other institutions like Fannie Mae and Freddie Mac were taken under government control
- All the countries who invested in investment banks became bankrupt, out of which one was Iceland
- Global Economy faced an enormous slowdown and created a panic in the financial market
- World trade fell by 40% in 2008
The bailout of the U.S. financial system helped the economy to revive. And obviously, we’re seeing the same thing all over again, today. Anyway, we hope we were able to explain the 2008 financial crisis. Some terms mentioned above are defined below.
Key Terms for the interested folks:
- Sub-prime Lending: This refers to giving loans to such people who don’t qualify in making the repayment on the scheduled duration
- Credit Default Swaps (CDS): These are a type of insurance against default risk by a particular company
- Collateralized Debt Obligation (CDO): It is a kind of bond/security consisting of a pool of mortgage securities submitted by various loan takers. Basically, a kind of structured financial product that pooled together cash flow generating assets. This asset pool was repackaged into discrete tranches and sold to investors
- Quantitative Easing: In order to increase the money supply in the market, the government applies this monetary policy, where it purchases all the shares of a falling company
- Bailout: Here, a business, an individual or the government offers money to a failing business to prevent the consequences that might arise from the business’s downfall
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