Factors That Led To Global Financial Crisis

Global Trade & Finance
Q. The factors that led to the Global financial Crisis of 2008-2009
Ans.
The Global financial Crisis in 2008-09 was a financially catastrophic event where actions based on greed
of few people shook the Global markets around the world. The ensuing credit crunch during this crisis
led to the demise of some of the long well-established institutions like Lehman Brothers besides pushing
the United States (US) economy into its worst recession since the great depression of 1929.Many people
lost their jobs and many others became homeless during this period. It was also a betrayal of trust of
investors’ money by these institutions that initiated these bad loans and thus trampled investors’
confidence in the markets. In order to prevent complete collapse of the financial system the US
government had to pump in huge amounts of tax payers’ money into the system for rescuing some of
their biggest financial institutions.
The main reason cited for the beginning of this crisis is stated as the default by people on their sub-
prime mortgages for their homes in US .A sub-prime mortgage is a kind of loan that is given to people
who have poor credit histories and they generally do not qualify for cheaper loans to buy house. Most of
these sub-prime mortgages were adjustable rate mortgage (ARM), which initially charged a fixed
interest rate that were small but in later stages converted to floating rate which increased in large
amount (upto 200 to 300 percent in some cases ) when US Federal Reserve increased interest rates in
the following years.
The crisis was also instigated due to the common belief among the general people that housing is a safe
investment option and that prices of houses are always on upswing due to greater demand and thus
their values cannot decline.
Factors that led to the crisis:-
1. Deregulation in The US financial industry
The repealing of the Glass-Steagall Act of 1933 by Gramm-Leach –Billey Act allowed banks to use
investor deposits for investing and trading in derivatives. The banks in order to earn hefty profits began
investing in risky assets with higher returns while borrowing on leverage i.e. debt. This increased their
tendency to lose more money in case some uneventful event happened in the financial markets.
2. Expansionary monetary policy by the US Central Bank
The US Federal Reserve engaged in expansionary monetary policy in 2001 by lowering down the interest
rates in order to overcome the recession that ensued after the dot-com bubble burst. This also resulted
in lowering of interest rates on adjustable-rate mortgages and thus incentivised borrowing by the
people across US for buying homes at cheaper rates. Many of these home buyers did not realize that
these rates would be reset in the next 3-5 years. The prevalence of lower interest rate also acted as
incentive for banks, hedge funds and other investors to invest in riskier assets in order to make higher
returns.
3. Signing of American Dream Down payment Act
The signing of the American Dream Down payment Act by President George Bush in 2003 allowed many
low-income buyers to avoid making the basic down payment that is required to buy their home. The
original intention of this act was to make more people own their home. In fact this was a classic case of
“Good intentions but bad consequences”. The president had signed this legislation as part of promotion
of his government’s goal to add 5.5 million new minority homeowners in US by the end of the first
decade of the new century. Most of these home buyers had no fixed source of income ,so when the
interest rate stated increasing in the later years ,these people were unable to pay and thus in the
process lost their homes while the banks’ lending them lost their money. Besides there was aggressive
promotion by loan brokers of these banks while not explaining risks clearly associated with these kinds
of loans as distributing more loans helped them to earning better incentives.
3. Creation of asset bubble by 2005
The prevalence of lower interest rates, backing by the government plus greed of banks contributed to
their lending huge amounts of money for home loans between 2001 and 2006. This resulted in the
doubling of sub-prime mortgages from 10 percent to 20 percent between 2001 and 2006 and over this
time it became a 1.3 trillion dollars industry. During this time many sub-prime borrowers also entered
the market with the intention of speculation believing to sell their assets when the price increases
further .Therefore they borrowed cheaply to buy more than 2 to 3 homes without even having fixed
source of income. This created an asset bubble where supply was more than the demand. Naturally
when the interest rates started increasing from 2004 onwards, these were the first people who
defaulted on their loan payments. The recovery of their houses by the banks did not help as these assets
were not paying in nature.
4. Pooling of Risky assets to back new financial Instruments
Banks generally pooled their loans to turn them into low risk assets products called mortgage backed
securities and sold them to their trading divisions or hedge funds. This was based on their assumption
that bringing together different categories of loans together collectively lowered the default probability
of these instrument altogether. These pooled mortgages were also further used to back new financial
instruments called Collateralised Debt Obligation (CDO’s) which were divided into tranches where each
tranche was defined by their exposure to default. Although the default probability of such instruments
were very high since most of these were given to sub-prime borrowers, the banks in collusion with
rating agencies managed to get them triple A rated and thus sold them to gullible investors .These
investors included some financial institutions in others countries ,pension funds as well as hedge funds.
They did not worry about the risk since they had insurance in the form of credit default swaps (CDS)
which were sold by insurance companies like AIG. As a consequence of that when the original home
borrowers started defaulting in their loans from 2006 onwards the value of these derivative products fell
sharply.
The result was that financial institutions in order to protect their remaining capital stopped further
lending among each other. This break-up of trust between financial institutions in the world resulted in
severe credit crunch in the markets thereby affecting operations financial institutions that used to
borrow amount for their working capital needs like Lehman Brothers and Bear Stearns leading to their
demise. Also failure of US government in bailing out the 150 year old Lehman Brothers further dented
the investor confidence in the markets thus contributing to the financial crisis
The US government in 2009 proposed government spending of around $1 trillion in order to improve
the condition of financial crisis. Apart from this the Federal Reserve also lowered down the interest rates
to 0.25 percent in order to boost consumption in the economy.
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Sources used for reference
1. https://www.canstar.com.au/home-loans/global-financial-crisis
2. http://positivemoney.org/issues/recessions-crisis/#1507142518426-c73618ad-c567
3. https://www.thebalance.com/what-caused-2008-global-financial-crisis-3306176
4. https://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are-still-being-felt-
five-years-article
4. https://www.thebalance.com/fed-funds-rate-history-highs-lows-3306135
6. https://cashmoneylife.com/economic-financial-crisis-2008-causes/
7. https://themarketmogul.com/financial-crisis-lessons/
8. https://georgewbush-whitehouse.archives.gov/news/releases/2003/12/print/20031216-9.html
9. The Big Short Book-Michael Lewis
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Global Trade & Finance

Q. The factors that led to the Global financial Crisis of 2008-2009

Factors that led to the crisis:-

1. Deregulation in The US financial industry

2. Expansionary monetary policy by the US Central Bank

3. Signing of American Dream Down payment Act

3. Creation of asset bubble by 2005

4. Pooling of Risky assets to back new financial Instruments

Sources used for reference

9. The Big Short Book-Michael Lewis

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