Global Financial Crisis - Explained

Read Time: 5 mins

The Global Financial Crisis was the downturn in the market that took place from mid-2017 and lasted until early 2019. Also known as the United States subprime mortgage crisis, the reason behind the crisis, as is well understood by the name, was the housing market of the US. The US housing market was valued pretty high due to lots of misinformation, this misinformation came into the knowledge of experts in mid-2017 and investors started taking money out of the market and as the awareness spread, more people started moving their money leading to the domino effect which led to the crisis.

How it all started?

In 2001, as we know, the U.S. economy experienced a mild, short-lived recession which happened due to multiple reasons such as the dot-com bubble, 9/11 and multiple accounting scandals. Although the economy nicely withstood the terrorist attacks, the accounting scandals and the bust of the dot-com bubble, the fear of recession really preoccupied everybody's minds.
To overcome the recession and to help people gain confidence in the market, the Federal Reserve lowered the Federal fund rates and that too by a huge margin i.e. from 6.5% in May 2000 to a mere 1.75% in Dec 2001, this led to a flood of liquidity in the economy. Although the lowered fed rate was not a scam but was the major cause of the crisis in 2008.
As the Federal fund rate was lowered, it became easier to borrow money, imagine yourself in that situation, if you'll be getting a home loan at a mere 2-3% interest rate, you'll definitely go and get one. The same happened all across America, more and more people started buying houses but as the supply was limited, people started to buy bigger homes and carry forwarded their older ones at higher prices and since getting a loan and the interest rate on a loan were not a problem everyone started paying the higher costs for the houses.

Scenario #1: Imagine a house valued at $300k in 2002, you bought the same and then as other people were also getting loans they became interested in your property and in 2003 it was valued at $400k and this domino effect led to that house being valued at $800k in 2008. However, in a 6 years time span, the actual value of that house might have risen only by 5-10%, thus whoever bought the house at $800k in 2008 has overvalued the property by a huge margin.
Problem: Overvalued Properties in the US

Scenario #2: Imagine you have savings and earnings to buy a house of around $300k, which you bought in the year 2003 but since you sold that property for profit, you moved to a bigger house of say $500k, you again sold that property as the demand was huge but the supplies were not and then you bought a property worth a million dollar in around 2008. Since your earnings were low but the bubble of subprime mortgage liquidity never let you see that as a problem.
Problem: Many people started defaulting on their loans.

Who all were responsible for the crisis?
The key players were the big banks and the Insurers who gave fallacious information regarding the ratings of multiple bonds and CDOs. A collateralized debt obligation (CDO) is a complex financial product that is backed by a group of loans and other assets. CDOs are sold to institutional investors and are rated by Insurers and other such agencies. A huge chunk of the CDOs came in the form of bundled mortgages at the time before the crisis and these CDOs were rated AAA (Best rating for any financial product) however the Insurers knew that they were not that safe but still gave those CDOs AAA ratings.
We have all heard of AIG, it has been the global powerhouse in the business of selling insurance for decades. But in September 2008, AIG was on the brink of collapse. The Federal Reserve issued, in exchange for 79.9% of the company's equity, a loan to AIG. The total amount originally at $85 billion was reworked and was brought up to an estimated $150 billion.
Irrespective of this huge buyout, the government was able to make a profit of $22.7 billion from the interest paid.

Who still profited from the crisis?

We all know how the market works i.e. no matter, whether the market is up or down, the person that makes money at the end of each day is the broker who is making the trade on someone else's money.
Also, the other kind of people who know something wrong is going on in the market and then they short the particular financial product.
Shorting a stock: In shorting a stock or any other asset, what we do is we bet against the growth of that particular company. Let's see this from a simple example: Suppose you know that the price of particular premium chocolate, priced today at $200, is going to plunge to $50 after 10 days. So what you do is, you lend it from a person today and tell him that you'll give it back on the 10th day. You sold the chocolate today at $200 and then waited for 10 days to pass. As the price dropped to $50, so you buy the chocolate at $50 and give it back to the person from whom you lend it, ending up with a profit of $150 in 10 days i.e. 200% profit.
In the real-world, you replace the chocolate with stocks, CDOs, and other financial products.

Now let's have a look at who all made a profit of the crisis and to what amount.

• CEO of Lehman Brothers, Richard Fuld
• Earned over $500 million during the crisis
• Goldman Sachs CEO Lloyd Blankfein
• Earnings of $11.6 billion for Goldman and almost $70 million in payouts.
• Bank of America CEO Ken Lewis
• Paid $10 million to the State of New York
• President of S&P Kathleen Corbet
• S&P paid $1.5 billion in settlements to the U.S. government

This is how a series of events led to more liquidity which further led to higher defaults and all trails led to the Global Financial Crisis of 2008. The I.M.F. Puts the Bank Losses From the 2008 Global Financial Crisis at $4.1 Trillion.