Brief Overview of What Caused the Global Financial Crisis of 2008

Dec 19, 2018 | 7 months ago | Read Time: 4 minutes | By iKnowledge Team

The global financial crisis started in the US with a bursting of the housing market bubble.  High levels of sub-prime loans led to a collapse in the property market and the stock markets. This led to a credit crunch among global financial institutions and the contagion spread across the world as lenders suffered losses and became bankrupt.

It’s been exactly ten years since the global financial crisis of 2008, when large financial institutions that had existed for decades were suddenly extinguished overnight. Apparently invincible establishments in the United States crumbled, a large number of American people lost their jobs and their savings and the ‘contagion’ spread across Europe and to some extent Asia too because economies are interconnected.

Have you ever thought why the crisis happened and how it originated?

The 2008 financial crisis is also called as the sub-prime mortgage crisis.  Let us define subprime. We know that borrowers have a credit rating issued by consumer credit rating companies based on their past borrowing history and repayment records. In the US, people with poor credit scores are issued mortgages at a rate, which is much higher than the normal rates.

The whole trouble started with this – too many sub-prime mortgage loans were given and this led to a housing bubble, as prices of real estate rose. Since the homeowners were individuals with already poor repayment records, many of them started defaulting on their loans because they could not afford the rates. The bubble built up over years with rising demand and easy loan money. Defaults led to homeowners selling off their houses or losing their houses and this led to a downturn in property prices. People were not able to recover the original price and this meant that they could not repay the lenders. The lenders in their turn were left holding assets on their books that were worth much less than what it had been originally valued at.

Cumulatively, the banking system had exposure worth several billions of dollars in subprime loans, which could never be recovered. They were looking at huge losses; worse, they did not have the money for their ordinary lending activities to the industry and the economy faced a credit crunch. One of the industries that particularly suffered was the automobile industry, which was already struggling and it was unable to get funding from banks. This was one part of the story.

Another part of the story was that many financial institutions were found to have been selling investors exotic derivatives products, linked to equities and debt instruments that were highly risky. The products were complicated and people looking for places to invest their money in them recklessly. When the housing bubble burst, the stock markets collapsed and so did the derivatives products that were based on them.

Lehman Brothers, a well-reputed investment bank, collapsed in September 2008 holding large exposures in commercial property. It was like a trigger for other large institutions that were struggling for survival. The US government finally came out with a rescue package with the US Federal Reserve infusing $236 billion dollars into the banking system. Various stimulus packages followed to jumpstart, inject life into the economy, and restore the confidence of the people.

The crisis spread to Britain as well; London is after all one of the financial capitals of the world. There were American banks operating in England while British banks had exposures to the US economy. There were calls to reduce interest rates and prevent a housing collapse such as what had occurred in the US.

In October 2008, the Australian government announced a stimulus package worth $10.4 billion. The package was intended to fight inflation, guarantee bank deposits while providing payments to vulnerable segments.

As the crisis spread, people started to pull out from the stock market and turn to investing in gold, bonds as well as currencies such as the Euro, which seemed more secure and safe investment avenues at that time. Gold prices in fact reached a record high of $1000 an ounce. Countries in South America started hedging against the US dollar.

The crisis, which blew up in 2008, left its mark on the global economy for years. Countries in Europe such as Portugal, Spain, Greece and Italy all suffered from a debt crisis. They had to undertake austerity measures that grabbed news headlines for a while.

The upshot of all this was that across the world financial regulators decided to clamp down on profligate lending practices. Banks and institutions were discouraged from selling exotic products, and there was more regulatory oversight on troubled sectors.

In India, the effect was much more diluted. This was chiefly because the domestic economy – especially the rural economy – was found to be much more robust and consumption demand from within was enough to keep the economy from slipping. Expansion plans in the corporate sector were however put on hold for a while. The government did announce some stimulus packages in the form of excise duty cuts in some products and sectors. By the end of 2009, the Indian economy had managed to come out of the global crisis with very little impact.

Insurance companies are generally conservative in the way they invest funds, which helps ensure a level of security even in times of crisis. Therefore, unit linked plans in general can be relatively safe to get exposure to equity markets. iMaximize Insurance Plan by Aegon Life for instance is a unit linked insurance plan, that though offers market linked returns, also provides protection. There are no allocation charges in this scheme and investors get the benefit of their entire money being invested.

From an investor’s point of view, the lesson to be learnt from the global financial crisis is that one should beware of bubbles; one should not invest in products that one does not understand and most of all do not take on too much debt. Always look at long term investment opportunities.

II/Dec 2018/4700

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