How did the 2008 Financial crisis start?
Personally, I am affected by this crisis as over a few months, I saw my investment values plummeted. It is not a happy event and I am sure it is true for many others too. It has been almost 4 years now and at the back of my mind, the financial crisis of 2008 is still fresh in my mind. I had done some research and the following below is a result of that.
The 2008 global financial crisis is considered as the worst economic slowdown since the Great Depression. There are various reasons that triggered global financial crisis. However “US housing market collapse” is assumed to be one of the main causes of financial crisis.
The collapse in US housing market is due to the following reasons.
Easy access to credit: Falling interest rates and rising availability of mortgages, combined with rising housing prices encouraged people to purchase homes.
Relaxed lending standards: To cater to growing number of mortgage seeker, lenders relaxed lending criterion which lead to increased number of sub-prime loans loans.
Inadequate regulation: As the innovations in US financial product increased, it required appropriate regulations to prevent increased complexity. Inadequate regulations lead to poor transparency and higher risk.
Complex credit derivatives: The use of debt derivatives such as Collateralized Debt Obligations made it very hard to recognize and control the lending problem, as the default rate started to increase.
Market collapse: The property boom led an over-supply of housing and prices could no longer be supported. As the prices decreased, it leads to increase in foreclosures that increased the home supply in the market. As the lending criterion were tightened, less consumers were able to repay that increased the problem and caused the market to collapse.
Apart from US housing collapse, other causes also led to financial crisis. Some of these causes are:
Credit Rating Agencies: Credit rating agencies such as Moody’s, Standard & Poor’s and Fitch were also responsible for 2008 financial crisis. These agencies granted AAA rating to those mortgages that were backed by securities called as MBS. These agencies were very profitable in last decade. They followed an ‘issuer-pays’ revenue model in which the body that issues security also looks for the rating and it pays to credit rating agency for the rating. This model creates a possible conflict of interest as it can lead to high ratings for risky mortgage backed securities
Mark-to-Market Accounting rules: According to this regulation, financial firms should consider their probable losses as cash losses. Although various financial instruments like mutual funds, deposits etc may provide good returns in future but current price of these assets were highly devalued. It resulted in forced liquidation and thus there was further decline in assets.
Banks decision for investment in risky projects: Poor decision making by the banks was also one of the reason for 2008 financial crisis. These institutions kept huge money of Mortgage Backed Securities despite of the sub-prime risk involved. Banks decision of financing risky assets and collapse in US housing market increased the complexity. It became very difficult for these lending institutions to roll over short term loans against the security. Eventually they had to sell the assets at lower price and suffered huge loss in business
Capital requirement of bank: According to various market experts, international regulation also resulted in 2008 financial crisis. According to this regulation, if banks and other financial institutions invest in riskier loans or investment, they can hold more capital. Banks turned the risky loans into securities and sold it to investors.
Government Economic Statistics: Many people blame government statistics for financial crisis. According to them these statistics were misleading and it did not reflect the true picture. These figures were used by Wall Street so that they could sell their over-valued products.
Impact of financial crisis
Financial crisis was a result of US subprime mortgage lending which spread to other countries via combination of regulatory weakness and market failures.Decline in US Stock Market: USA stock market declined considerably as a result of financial crisis. The Dow’s fall of more than 50 percent was similar to 54.7 percent fall in the Great Depression. The decline was started in October 2007 and it accelerated in year 2008.
Losses to investors: Due to 2008 financial crisis, institutional investors as well as individual investors had to bear huge loss in mortgage backed securities and other such products. Banks also took a beating and suffered USD 600 Billion loss. Several major institutions like Lehman Brothers, Citigroup, Merrill Lynch etc either failed or were acquired by other companies.Freeze in inter-bank credit: Failure of banks fuelled anxiety in international banking industry resulted to freeze in inter- bank lending which resulted in Liquidity crunch in the market.
Increased unemployment: As the companies suffered loss, there were many job cuts. These job cuts were not limited to financial sector but it affected various other sectors such as Transportation, Information Technology etc. This lead to decrease in consumer spending since the people didn’t have any money to spend. As money was not available in the market, people could not do business and it resulted in increased unemployment.
Global decline in business: With the decrease in consumer spending, demand was reduced which affected business considerably. Several industries such as airline, automotive etc were impacted due to 2008 financial crisis.
Bailouts: Various governments announced bailout packages to tackle the growing financial crisis. Bailout package of USD 700 Billion was announced by US government for its banking sector, Bailout package of More than USD 200 Billion was announced by Germany and Britain announced bailout package of USD 500 Billion to overcome this crisis.
As the reasons of 2008 financial crisis are quite clear, therefore it has become evident that most of the cash was used to repair the financial system. This cash is also used to repair balance sheets and soothe the financial pain.
Future Outlook
As the financial institutes were badly hit by the global meltdown, it has become very evident that there would be restructuring and consolidation of such institutes. Several takeovers have already taken place e.g. Barclays capital acquired Lehman brothers, American bank took over Merrill Lynch etc.
Economies in several countries suffered due to financial crisis that occurred during 2008. It is expected that developing nations like China, India etc would act as saviour of the developed nations. The emerging countries were less affected than developed nations, thus these countries are likely to attract better investment from other developed countries which are facing the risk of recession. This is yet to be seen.
And we are now in the year 2012, still the effect of the crisis in 2008 is still felt. In the US, economic data shows that recovery is still week but it is making a slow and steady recovery. On the other hand , Europe is now in crisis starting with the debt problems of Greece which may now spread to Spain, Portugal and even Italy. Is Europe current problem due to the 2008 financial crisis. Well this is hard to say but I am sure that there is something to do with it as European banks also had investment in the US, thus highly probably got into the subprime mess too.