The 2008 Global Economic Crisis Explained

global-financial-crisis-artThe global economic crisis was kick-started by the collapse of one of the biggest global financial services firms; Lehman Brothers in September 2008. The Lehman Brothers collapse almost brought down the global financial system. It took billions of dollars of taxpayers’ money to keep the world’s financial system running. Nevertheless, the ensuing credit crisis turned an already nasty economic downturn into the worse global economic recession in 80 years.

Massive fiscal and monetary stimulus prevented a catastrophic depression however, recovery still remains feeble compared to previous post-war upturns. The GDP of many countries is still below pre-crisis peaks especially in Europe where the global economic crisis gave birth to the euro crisis. The effects are still being felt to date in America even as the Federal Reserve prepares to wind down the QE (bond buying) stimulus program. With more than 5 years hindsight, it’s clear that the global economic crisis had multiple causes.

Causes of the global economic crisis

The most obvious cause of the global economic crisis was the financiers themselves especially those that claimed they had found an effective way to eliminate risk when they had in fact lost track of risk completely. Central bankers among other financial regulators are also to blame because they tolerated rogue financiers. The macroeconomic backdrop also played a role. Years of stable growth and low inflation made global financial industry players complacent and greedy at the same time.

Asia’s saving glut also played a role by pushing down the global interest rates. European banks were also borrowing greedily from America’s money markets a few years before the crisis and using the funds to buy ”dodgy” securities. All these factors combined fostered a debt surge which seemed low risk globally. A few years before the crisis, US financiers had started irresponsible mortgage lending. Mortgage loans were being offered to borrowers with bad rating who struggled to meet their repayment obligations.

These high-risk mortgages were being passed on to financial engineers in big banks who would then package them into low-risk securities by combining the mortgages into pools. It is important to note that pooling works perfectly when the risks of individual loans are uncorrelated. This wasn’t the case as seen later in 2006 when America’s real estate market slumped nationwide. The mortgage pools were used to back CDOs or collateralised debt obligations (special types of securities) which were divided into tranches according to default exposure risks.

These seemingly safer tranches were then sold to the public who bought them since they had a triple-A credit rating from top rating agencies like Standard & Poor’s and Moody’s. This was a dire mistake. The agencies weren’t as critical as they should have been when giving excellent ratings. This can be attributed to the fact that the credit rating agencies were being paid by the same banks that created CDOs.

Investors started rushing for these securities because they appeared safe and also because they were offering high returns in a low interest rate environment globally. Low interest rates globally created a favourable environment for hedge funds, banks and other investors to start hunting for riskier assets which offered higher returns. The low rates also made it highly profitable for such institutions to borrow and use the excess money to amplify their own investments on assumptions that returns would surpass borrowing costs. That is precisely what happened.

Housing to money markets

By now you might be asking yourself how the crisis spread from the housing to the money markets. Well, when the U.S. housing market turned, a chain reaction took place exposing weaknesses in the global financial system. Pooling among many other clever financial engineering strategies didn’t offer investors the necessary protection. Mortgage-backed securities fell in value. Supposedly safe CDOs became worthless despite having the seal of approval from rating agencies.

It became very difficult for ”suspect” assets to be sold at any price or be used as collateral for short-term funding relied on by many banks. This in turn dented many banks’ capital when accounting rules required banks to re-evaluate their asset prices at current prices to acknowledge paper losses which weren’t necessarily incurred. Trust began to dissolve fast in 2007 before Lehman’s bankruptcy when banks started to question their counterparts’ viability. Banks and other wholesale funding sources started to withhold short term credit causing those heavily reliant on it to fall. Northern Rock (A British mortgage firm) was the first casualty in 2007.

Highly complex debt chains became extremely vulnerable. AIG was buckled days after Lehman Bankruptcy following overexposure on credit risk protection products. It became evident that the entire system had been built on a very flimsy foundation. Banks had watched their balance sheets bloat without setting aside enough capital to absorb potential losses. Banks had in fact bet on themselves using borrowed money, a gamble which had paid off during good times but proven to be catastrophic during bad times.

About the global economical crisis: The role of regulators

Bankers aren’t the only people to blame for the global economic crisis. Central bankers among other regulators also share responsibility for mishandling the whole crisis, failing to manage economic balances and also failing to carry out their oversight role properly. One of the biggest errors committed by regulators was letting Lehman Brothers become bankrupt. This incident played a crucial role in destabilising the financial markets by multiplying panic.

All over sudden, the lending market froze. No one was lending. Non-financial institutions responded by hoarding cash as a result of being unable to borrow money to pay workers and suppliers. This caused a seizure in the economy. Although the decision to allow Lehman Brothers to go bankrupt was aimed at reducing government intervention, it resulted in more intervention. Regulators failed by allowing global current account imbalances to go unchecked. They also failed by allowing the housing bubbles.

The entire developed world had a role to play including Europe. It was worse for Europe since Europe already had internal imbalances that proved to be more significant than imbalances in China and America. Europe’s imbalances were caused by excessive inflows to overheated real estate markets in Spain and Ireland. The ongoing Euro crisis is as a result of the markets agonising on the weakness of many European banks with bad debts caused by a property bubble burst.

Clearly, central bankers could have done more. They however claim that it would have been very difficult to contain the credit and housing boom using high interest rates. It is however important to note that central bankers had many other regulatory tools i.e. forcing banks to set aside adequate capital as well as lowering maximum loan-to-value mortgage ratios. The world seems to have learnt from the past. It will however take longer for the global economy to recover completely given factors like global conflict.

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