Running head: 2008 FINANCIAL CRISIS 1

2008 Financial Crisis

Student’s Name

Institutional Affiliation
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2008 Financial Crisis

Introduction

The world economy in 2008 went through one of the most perilous meltdowns since the

1930’s Great Depression. The crisis, which started in 2007 at a time when the high prices of

homes in the US suddenly dropped, spread rapidly, to the whole of the United States first and

then to the other financial markets across the globe. The financial crisis of 2008 occurred due

to deregulation, securitized mortgages, low-interest rates, speculation, credit swaps, bursting

of the housing bubble, and the bankruptcy of the Lehman Brother. In its wake, the crisis led

to unprecedented rates of unemployment, loss of income, and a great recession.

Causes of the Crisis

1. Deregulation

One of the biggest drivers of the events that took place before the financial crisis of 2008

was deregulation. The 1993 Glass-Steagall Act was repealed in 1999, allowing banks to

utilize their deposits in investing in market derivatives (Smirniotopoulos, 2016). Lobbyists

from the bank’s side claimed that they needed this deregulation to compete with other foreign

financial institutions. However, they pledged to invest only in the low-risk derivatives to

safeguard the interest of their clients. The subsequent year, an Act called Commodity Futures

Modernization exempted a wide range of derivatives such as credit default swaps from

regulation. It overruled state laws that previously outlawed gambles such as the one involved

in the credit default swaps. During this time, the financial sector was marred with high

competitiveness as well as comparatively lower margins for a majority of the standard

investments. Due to this existing market condition and deregulation, players in the financial

markets developed a range of financial products most with speculative tendencies and

riskiness.

2. Securitization of The Subprime Mortgage

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Another key contributing factor to the financial crisis was the manner in which subprime

mortgages were securitized into Collateralized debts obligation and mortgage-backed

securities (CDO and MBS, respectively). Following the deregulation, investment bankers

were given the freedom to come up with all manner of products, most of which were

speculative in nature (Kotz, 2015). An example of the innovation that they created was the

auction of mortgage payments to other market actors. Banks which customers borrowed

money from embarked on an exercise of selling mortgage-backed securities to willing

investment bankers and banks who would later resell them to other investors.

Consequently, these investment banks made collateralized debt obligations (CDO) as a

new financial product or derivative. CDOs contained several debts obligations ranging from

home mortgages, student loans to car loans. Because the financial markets are filled with

investors harboring diverse risk preference, there was demand for derivatives with diverse

types of yield rate. In due time, the prevailing derivatives failed to meet the needs of all

investors.

3. Low-Interest Rates

From 1999 to 2004, there were sustained low rates of interest that made the ARMs

(adjustable-rate mortgages) seem considerably attractive to the prospective buyers. The low-

interest rates were in part driven by the huge current account deficit in the US and mirrored

by other nations such as China who devotedly bought the US treasury bonds. Such interest

rates were also as a result of the Fed lowering, which was justified by the prevailing

economic pattern. The Fed, as well as other major Central Banks in the world, continued

pumping liquidity in their respective credit markets to guarantee that the credit flowed at their

recommended low-interest rates.

4. AIG and Credit Swaps

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The American International Group, which is the largest insurance company in the world,

played a crucial role in the creation of the 2008 financial crisis. The company was selling not

only regular health insurances but also engaged in the trade of financial market derivatives.

One of the derivatives was the credit default swap. The credit default swap acted like

insurance policies for the investor. Consequently, whenever an investor bought the CDS, they

committed to paying some quarterly premium to the American International Group.

Whenever the CDO of the investor defaulted, then AIG paid such investors for their losses

(Flyn 2012). In comparison to other insurance firms, AIG did not only sell the CDS to

safeguard the holder of CDO but also auctioned to the speculators in the market effectively

betting against other CDO that they were not affiliated to them. They could sell them also in

large quantities because of the nonexistence of CDS regulation requiring to set some money

aside. The company paid hefty bonuses for their workers whenever they signed the contracts.

When eventually most of the CDO’s failed, and this insurance company could no longer

protect the investors, it became evident that in spite of being the largest insurance firm in the

world AIG could not similarly pay its debt obligation as well.

The AIG managers were not the only managers who were driven by greed to boost their

revenue to the top. The managers of the investment bankers were equally as greedy. Top

players such as the Lehman and Goldman Sach discreetly bet on own CDOs. They sold them

without revealing to their client their intention. Buying the CDS from American International

Group with an asset volume amounting to $22 billion, Goldman would bet against another

CDO which it did not own and still get remunerated whenever it failed.

5. Crisis at the US real estate and housing bubble

As mentioned earlier, players in the financial sectors came up with speculative financial

derivatives which they traded in their own market. The banks sold the mortgage-backed

securities to investors and other banks both in America and across the world. Against a
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particular fee, the repayment claim and interest were transferred to a buyer. The rates of

default were low from a historical perspective, mainly because of the higher underwriting

standards and also due to the belief that they were secure as a result of rising prices in the real

estate sector. Therefore, banks and other investors such as retirement and pension funds

heavily invested in the mortgage-backed securities because they guaranteed a continuous and

steady flow of interest payments. This demand for these new financial instruments increased

significantly, and banks ultimately failed to stimulate market demand (Rose & Spiegel 2012).

The prime mortgage taker’s maximum capacity was reached. As a result, banks in the US

began issuing subprime mortgages, even to borrowers who did not provide income or

employment proof. They did so to create additional mortgages in the market. The banks

promised flexible and low-interest rates. They also diminished the payment down, and hence

several mortgage arrangements enable the middle and low-income citizens to borrow money

to buy houses they could not ordinarily afford. The housing prices in 2006 reached their

peak, prompting the majority of the buyers to buy houses not for their personal uses but to

sell to other customer and in the process, making easy profits.

The boom in the housing sector was created, and what followed was a downward trend.

The default rates in subprime mortgages soon began to rise because the borrowers could no

longer serve their monthly payments. The Fed increased the rates of interest to 5.25 % further

stirring delinquency of loaners (O’Connor, 2014). The subprime mortgages were particularly

hit hard by this move. Their monthly payments heavily rose with the rise in interest rate. The

aftermath of these default event was that banks and investors of mortgage-backed securities

took over the ownership of houses whose owners who defaulted. With the prices of houses

still being extremely high, the financial institutions still had the chance to sell the house in

their possession at a profit, primarily because the emerging house prices safeguarded the

investor from making losses. However, the supply of house in the market soon surpassed the
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demand indicating an immediate stagnation of the house prices. As a result of this stagnation,

the prices of houses dropped. The bubble in the real estate sector busted triggering a domino

effect across America and the rest of the world.

6. The bankruptcy of Lehman Brothers

Lehman Brother was one of the largest global financial services companies in New York.

It had involved itself with the selling of dodgy financial instruments using its BNC mortgage.

The bank by 2008 held real estate whose value was over 30 times more its capital (Stow,

2018). Furthermore, it was over borrowing to funds all its mortgage investments. When the

trouble came knocking, the government of the United States refused to bail out the company.

With a debt and asset of $619 billion and $639 billion respectively, the filing of bankruptcy

by Lehman Brothers was the biggest in history because its assets far surpassed those of

former bankrupt companies such as Enron and WorldCom (Sing, 2018). The bankruptcy of

this firm marked the time when the financial stress in the world erupted into the full-blown

global financial crisis.

Consequences

1. Erosion of Market Capitalization

The 2008 financial crisis led to the erosion of market capitalization. In the wake of the

collapse of the Lehman Brothers, the erosion amounted to $10 trillion in the global equity

markets. This was the biggest decline in a month. Furthermore, the United States from 2008

to 2009 lost stock wealth amounting to 7.4 trillion (Pew, 2010). The figure per U.S household

on average was about $66,200.

2. Investor loss

The bursting of the housing bubble and the ensuing financial crisis had severe implication

for the investors. Investment banks, retirement funds, and hedge-funds made colossal losses

when the mortgage-backed securities and collateralized debt obligations defaulted. Similarly,
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private investors and smaller institutions who had put their monies in the CDOs to make

profits arising from interest-earning also lost large amounts of money.

3. Loss of Value in Real Estate

Real estate wealth amounting to $3.4 trillion was lost from 2008 to 2009 according to the

reports provided by the Federal Reserve. This was about $ 30,300 per household in the

country (Pew, 2010). Moreover, 500,000 further foreclosures were recorded during the

financial crisis’s acute phase in comparison to what was projected based on the estimates of

September 2009 CBO.

4. Loss of jobs

The 2008 financial crisis had far-reaching impacts on employment in almost all countries

around the globe, resulting in the doubling of rates of unemployment as well as a reduction in

tangible jobs. In the United States, this financial meltdown cost 5.5 million jobs as a result of

slowed economic growth. Even economic powerhouses like the United Kingdom, France,

and the US, have only begun recovering from such unemployment menace, while others,

including Greece and Spain, are still struggling.

Conclusion

The 2008 financial crisis is, without a doubt one the biggest jolts to the financial systems

in over a century. It pushed the global financial system to the brink of collapse. Its aftermath

brought about a serious recession, which resulted in an unprecedented drop in prices of

houses and an increase in unemployment. The crisis started in the US and was triggered by

the repealing of regulations in the financial sector that disallowed speculation and other

dodgy activities. Such deregulation encouraged a majority of financial institutions to take part

in the trade of derivatives. These instruments were so profitable that they prompted the banks

to increase their appetite for more mortgages. Therefore, they started issuing interest-only

debts obligations which subprime borrowers could afford, even those without formal
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employment. The cheap mortgages increased consumer demand for the houses, eventually

triggering a market disequilibrium. The oversupply in the market for these homes led to a

sudden drop in prices. Investor in the wake of this dip in prices could no longer pay the loan

back, and the housing bubble crumbled. The crisis in the US financial market soon spilled all

over the world, leading to unprecedented rates of unemployment, erosion of market

capitalization, stock value, and loss of investor’s money.

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References

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financial crisis hit and is it the largest bankruptcy filing ever? Retrieved from

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