Introduction
The global financial crisis is when the global banking systems and financial markets experience a lot of stress due to an uncontrollable economic trend. The period, mid-2007 to early 2009, saw a decline in financial markets and banking systems in America and other parts of the world. The crisis began in America when the country’s housing market collapsed, and all economic activities related to the sector experienced a strain. The crushing of America’s housing market created a ripple effect on the whole economy and affected several other countries worldwide (Chen et al., p. 5). Massive job losses amounting to millions of unemployed emerged as America and other leading economies experienced their worst recession of the 21st century. The 1930s Great Depression was the worst recession experienced in history, while the 2008 recession came second (NĂĽtzenadel, p. 6). This paper aims to assess the causes of the global financial crisis and its impacts on the world economy.
Details
The financial crisis of 2008-2009 occurred in phases that compounded the economic issue. It began with the falling of house prices in the United States and a rise in the number of borrowers who could not make payments to their loans. The prices of houses were highest in 2006 (Griffin et al., p. 1008). The prices began to fall after this, and the number of loan defaults increased. The rise in defaults led to the repossession of houses by lenders who could not sell the homes at higher prices than the loans borrowed, leading to stress in the financial system. The sale of MBS declined as investors were less willing to purchase them, while those holding them were focused on selling their loans. Consequently, the net worth of MBS declined. Foreign banks that had invested in America’s housing market experienced the impacts of the decline in their respective nations. The crisis finally peaked with the fall of the Lehman Brothers and other American financial organizations, leading to panic and an economic crisis.
Overexploitation of the Economic Environment
The financial crisis was caused by the overexploitation of a favorable economic environment, leading to excess risk-taking by financial lenders and borrowers. The economic conditions in America and most leading economies were good before the economic crisis. The United States was experiencing low unemployment rates, inflation, and interest rates. Economic growth was steady and robust and supported the increase in house prices. The continued growth of the economy and the stability in the housing market created an environment where the prices were not expected. As a result, a trend of imprudent borrowing emerged due to the guarantee that the economy and the housing market would continue to thrive.
Most of the borrowing was focused on several areas, including purchasing and developing houses. Entrepreneurs identified the housing industry as one of the most feasible investments. Investors made up a significant percentage of individuals who engaged in risky borrowing. Borrowers made short-term profits by purchasing houses, making slight renovations, and selling them at higher prices. Subprime borrowers were allowed to participate in short-term profit ventures despite the high risk of default. The environment was similar in European counties, and households were involved in the same trend of borrowing in these areas. A significant fact that became evident during the period was that most of the loans for purchasing houses were close to and sometimes above the purchasing price. The focus on focus on housing market led to a concentration of risky loans in one sector of the economy, making it vulnerable.
It created a market situation where financial institutions had large percentages of risky loans issued to borrowers with poor credit scores. Most borrowers could acquire risky loans because of a combination of factors. Some elements included a favorable economic environment that supported the housing sector for several years and the need for lenders to become more competitive. A combination of these factors began to contribute to the crisis that was not considered during the period.
Overexploitation of favorable market conditions was evident through lenders who provided large, risky loans for various reasons that affected their businesses. One of the reasons for the loans was the high competition between financial institutions, as each organization sought to provide larger housing loans. The goal of every business is to make a profit for its shareholders. Thus, banks took the risk because the provision of large housing loans was a profitable venture during the period. Competition between lenders became high due to the favorable market conditions and the need to achieve high outcomes by individual financial institutions. The increased competition redirected the focus of lenders from taking note of a progressing problem in their market.
The lack of borrower assessments caused the provision of large volumes of risky loans to determine their ability to repay loans. Credit assessment of every loan application is an essential part of the lending process. Banks have to measure whether a borrower is a worthy risk to ensure that they can maximize their profits (Olobo et al., p. 307). It is common practice in the financial sector, and its lack before the crisis is concerning. Part of the factors that may have contributed to the lack of scrutiny of borrowers may be the expectation that the favorable market conditions experienced during the period would continue. Another reason for the lack of assessment of borrowers was the lack of expectation that lenders would incur losses from providing such loans. Therefore, investors received large loans called ‘mortgage-backed securities (MBS). MBS were housing loans that contained several individual mortgage loans with different qualities. The loans would later become opaque and complex with time. However, lenders continued issuing MBS, and external agencies rated them as safe loans despite the rising concerns over their nature and issuance.
Borrowers who acquired MBS believed they received low-risk loans from financial institutions and were motivated to take more mortgages. The packaging of MBS was in a way that made the loans be perceived to bear low risks to investors so that their uptake could increase. The approach created a market trend where lenders were sure that most of the loans they issued would continue to be repaid even in situations where some of the loans in the MBS packages were not paid. The packaging of MBS managed to attract investors within and outside America. Large banks in the United States and foreign banks in Europe and other economies invested in the housing market with the expectation that they would receive higher returns than what they would have achieved from investing in their local markets.
Over-Borrowing by Investors and Banks
The financial crisis was caused by increased borrowing from both investors and banks. Investors and banks in America and foreign countries engaged in increased borrowing after they realized the potential mortgages presented to banks in terms of profits. The increased borrowing aimed to increase their purchasing ability of MBS products and their lending ability, respectively. The borrowing increased the potential to make large profits. However, it also increased the risks faced by the borrowers. Therefore, when house prices began to fall, investors and banks incurred significant losses because of excessive borrowing. Moreover, some investors and banks borrowed money for short periods because the market guaranteed short-term profits from purchasing properties that they expected to sell quickly. The price fall created a new problem where they had to rely on borrowing to pay the short-term loans and incurring new loans that were issued for varying periods.
Lack of Policies and Regulations
The global economic crisis occurred due to errors made in regulations and policies. The government did not have strict measures to regulate MBS products and subprime lending. Existing laws were insufficient to ensure that lenders engaged in healthy economic practices. The lack of adequate regulation was evident in the creation and issuance of MBS to investors. A review of the MBS indicated that they were opaque and complex, which prevented investors from having detailed knowledge about their nature. The lack of regulation is also evident because there were many individual borrowers with huge loans, making it difficult for financial institutions to guarantee that all investors issued with mortgages could repay them. Most governments and central banks did not identify the crisis until it was too late for effective interventions. The existence of policies would have ensured that central banks regulated the creation and issuance of MBS, and governments would have identified the increasing rate of home loan defaults.
Conclusion
Therefore, the financial crisis occurred because both borrowers exploited the favorable economic conditions to engage in financial activities that weakened the housing market and affected entire economies because of the overinvestment in the sector. Financial institutions are involved in high risk-taking due to the favorable market conditions supporting large loan issuance. As a result, the institutions provided individual borrowers with high-risk loans with minimal consideration of their ability to pay. Lenders also failed to properly assess investors before the issuance of loans, which led to a large pool of borrowers who could not pay when the market began to decline. Borrowers also took advantage of the situation and over-borrowed from lenders because of the guarantee that they would achieve short-term profits from purchasing houses at low costs and selling them at higher prices. Foreign investors also contributed to the issue by increasing their investments and facilitating the development of complex and opaque MBS. The crisis was enabled by the lack of sufficient regulations and policies that would have ensured that relevant parties were constantly checked and proper financial practices were being used. These factors led to the worst economic crisis of the 21st century because the lives of millions of people were affected by job losses and financial constraints.
Works Cited
Chen, Wenjie, et al. “The Global Economic Recovery 10 Years after the 2008 Financial Crisis”. IMF Working Papers, vol. 19, no. 83, 2019.
Griffin, John M. et al. “What Drove The 2003-2006 House Price Boom And Subsequent Collapse? Disentangling Competing Explanations”. SSRN Electronic Journal, 2018.
NĂĽtzenadel, Alexander. “The Financial Crisis of 2008—Experience, Memory, History”. Journal of Modern European History, vol, 19, no. 1, 2020, pp. 3-7.
Olobo, Maurice, et al. “Credit risk management practices and performance of commercial banks in South Sudan.” Journal of Financial Risk Management, vol. 10, no. 03, 2021, pp. 306-316.