US financial crisis of 2008
-By Divyansh Kaul
Basic overview of the Crisis
The US financial crisis of 2008 is also known as the ‘subprime mortgage crisis’ or it is often referred to as ‘The Great Recession’. This crisis dismantled the international financial system and led to the disintegration of the U.S. housing market, the collapsing of several great investment and commercial banks, mortgage lenders and insurance companies. Millions of Americans were extremely affected by this crisis. The US Government had no other option left and was forced to offer bailouts so that these institutions can survive and exist in the market. This didn’t happen overnight. There were several components present which led to the crisis, and their consequences remain to this day. So let’s take a look and find out what actually happened in The Global Financial Crisis of 2008–2009.
Causes of This Crisis
1. Loose Monetary Policy and low interest rates — The Federal Reserve (Fed), the central bank of the United States, reduced the interest rates from 6.5% in 2000 to 1% in 2003. This considerable decline in the rate of interest permitted banks to give consumer credit at a lower interest rate and also allowed them to grant even to “subprime,” or high-risk consumers. Local citizens took benefit of this low-priced loan to purchase houses as the proceeds mainly went into the housing market.
2. Financial Deregulation — In the US earlier there was an act called the Glass-Steagall Act of 1933. According to this act commercial banks, investment banks and the insurance sector were separate from each other and were not allowed to enter each other’s markets but in 1999, President Clinton abolished this act, which allowed these three sectors and institutions to merge which later on led to the failure of big banks and financial system.
3. Ratings Agencies — Around 2007–08 Credit rating agencies such as Moody’s and many others gave AAA ratings to Credit Default Swaps (CDS) plus all the investment banks (including Bear Sterns and Lehman Brothers) and they declared all the investment options safe because they were not able to quantify the amount of risk associated with them and they were unable to say which instrument will fail in coming time.
4. Sub-Prime Mortgages — Credit Default Swaps (CDS) and Collateralized Debt Obligation (CDO) also triggered the crisis. Subprime families were not able to pay back their loans because of various reasons such as the Fed’s prolonged low-interest-rate policy of 2002–04 increased the demand and price of housing. Due to rising inflation in 2005, the Fed increased the interest rates which eventually led to an increase in the default rate. The default rate increased rapidly and reached 5.2% till the third quarter of 2008 and ultimately the US housing bubble burst.
Effects of the Crisis
The U.S. financial crisis was also the longest since The Great Depression of 1929. It lasted about 18 months i.e. from December 2007 to June 2009. The subprime mortgage crisis triggered the situation which further led to a global banking credit crisis. As we know that so many people were not able to pay back the mortgage loans they took and numerous other financial institutions had also failed. Due to this, the banks faced a lot of problems as they were left with fewer reserves so they could not grant much credit and their lending power reduced. The level of unemployment reached approximately 10% in the USA and a large number of countries went bankrupt. World trade also fell by 40% in 2008. The crisis had caused severe panic in financial markets which encouraged the investors to take their money out of risky mortgage bonds as well as equities. Big financial institutions like Lehman Brothers went bankrupt and other financial organizations such as Fannie Mae and Freddie Site were being taken under the control of the U.S. government.
Government’s response to the crisis
Finally, in September 2008 the US government and The Federal Reserve started looking for solutions to sustain the financial markets and rescue the other banks from collapsing. They started a plan named the Troubled Asset Relief Program (TARP) which comprised of purchasing troubled assets from the banks, to reduce uncertainty in the market. It was signed on October 3rd, 2008 and the Treasury proposed a $700 billion plan. Similar plans had been executed around the world to stabilize financial systems and promote economic activity.
