The Great Recession 2008 — Cause and Effect

— — by Shivam Kumar

The 2008 crisis was one of the biggest economic crisis of century which almost collapsed the whole banking system in US. This one started from US but soon it reached several countries in terms of shortage of product and services provided by US. In this article we would try to explain the reasons and effect of great recession or 2008 Financial crisis.

In simple words what was the main reason of 2008 economic crisis?

Answer: The craze of buying Real estate in United states and greed of some Financial institution.

From 1990s to 2007 the prices of houses in the US increased by a remarkable 130% and this was due to aggressive purchasing of houses in US. The question is why people were crazy for buying houses and why prices of houses increased , The answer is

1. Low interest rate in US from 2000 to 2003, interest rates in USA were lowered from 6% to 1% after the attack at World Trade Centre. So, people began to take more loans to buy homes(Home mortgage loans). Hence, the demand for houses increased and hence its price increased.
2. Policies of Savings flowed from China, Japan, Germany & the oil-exporting middle-eastern countries into the US economy. This resulted in the increase of supply in funds and decrease in interest rates.
3. The great Moderation :- The period from 1980s to 2007 in the US economy there was very low inflation, low-interest rates, and stable growth. Since then people in America became confident and thought of taking high risks and started taking home loans and buying new homes.

The race of buying homes was not only till Prime borrowers, it speeded up to sub prime borrowers (the borrowers with low creditworthiness). There was also the golden opportunity seen by Banks. They were assuming that prices will always rise and, if the sub-prime borrowers are unable to repay their loans, banks can sell the houses and recover the loan. House prices rose further and US households became leveraged (It means they borrowed more relative to their income).

But the time came where all this bubble needed to be burst :

In September 2007 prices declined by as much as 25% and the housing market became saturated. Everyone who needed a house had one. So, there was a decrease in the demand for houses. And now from 2004 to 2006 the govt increased their rate of interest and home loans became expensive.

Impact of bubble burst :

1. As prices of houses fell, people began to default on their home mortgage loans. Since, banks had given loans to those who don’t have that kind of steady income so they can repay their loans i.e. subprime borrowers and their homes were worth less now (due to reduction in price), they no longer had the incentive to repay their loans which became very expensive (due to the increase in interest rates).
2. Now banks had the only option to sell the homes of defaulters who had kept houses as mortgage. But the problem didn’t end there since there were a lot of defaulters’ homes and already the prices of homes were very low , it resulted in the high losses for banks. This was essentially a sub-prime mortgage crisis and also borrowers couldn’t re-finance the loan as interest rate had been increased. Since banks had given loans on adjustable rate when it was low, people were able to pay and default rate was comparatively low but when interest rate increased, the default rate also increased and due to this reason people were unable to re-finance their existing loans.

This bubble could have been restricted to the housing market in the United States. But, it spread to the financial markets and to the whole of the world and became a global financial crisis.

Now new chapter of financial institutions started from here :

1. Since home mortgage loans are an asset for any financial institution i.e. they got interests regularly from several financial institutions by selling those assets. By doing this, they not only tried to get some interest but also to decrease risk . Then they issued securities backed by these assets known as Mortgage-Backed Security (MBS) which could be traded as shares. It means if an investor purchases these, securities he will get shares in principal and interest rate. MBS became a popular investment option as the interest rates in the US were very low then.
2. Credit Default swap : It was a kind of security bought by the investors who needed to insure it against the losses in security.

One of the most important reasons was — Lack of government regulations:

Since investments banks didn’t have that kind of rules and regulations like some commercial banks who were required to maintain large capital, which acted as buffers to decrease fragility. But, as these Investment banks remained outside the purview of regulations, they assumed a lot of debt. They borrowed money for the short-term and invested them in long-term assets. There was a maturity mismatch. Investors began to withdraw funding and there was a run on the shadow-banking system, which led to the decline of one of the most oldest investment banking firms in US i.e. the Lehman Brothers.

In this way, the 2008 financial crisis led to a worldwide economic recession as US was among the leading importers and exporters for several countries which resulted in high unemployment and falling stock price of several companies all over the globe.