What caused the 2007 -2008 Global financial crisis?

To better understand the causes and effects of the 2008 financial crisis, we must first understand simply what a financial crisis is. Put simply, a financial crisis is a situation where the value of assets (any resource owned or controlled by an economic entity) drop rapidly and is often triggered by a panic or a run on banks.

The global financial crisis that hit in 2007 was the most serious economic shock since the Wall Street Crash of 1929. It started with a lending crisis in 2007 and expanded into a global banking crisis with the failure of over 465 banks in USA between the years 2008 to 2012 (according to the Federal Deposit Insurance Corporation) including the bank Lehman Brothers, a bank that people thought was very stable, in September 2008. It led to a severe recession in the UK and many major countries.

What caused the Global financial crisis?

In the early 2000s investors in USA as well as foreign investors started to invest in the US housing market with the aim of getting high returns at lower risk due to the fact that there were low interest rates during this period thus encouraging borrowing since it’s less money to pay back. This as a result led to lots of investors taking risks and pouring excessive money into this market. This, initially indeed did seem to provide a false sense of security as house prices were rising.

Investors wanted to invest in more mortgage-backed securities (lots of individual mortgages bundled together and sold as shares) as they were deemed to be solid and stable. Therefore lenders had to create more MBSs so they started giving out loans more excessively to people with worse credit (subprime mortgages) Not only were many individual borrowers provided with loans so large that they were unlikely to be able to repay them, but fraud was increasingly common –There was data proving that MBSs were indeed a safe place to invest in, however it wasn’t. Regardless these MBSs still received lots of investment.

The US housing was in what is known as a bubble, whereby the price of these houses was increasing rapidly due to irrational decisions. However this bubble essentially ‘burst’ since the increasing house prices meant that people couldn’t keep up with payments since the rate of inflation was greater than the wages people were receiving. As a result, these houses had to be put back on sale but there weren’t buyers and so demand was decreasing i.e. there was excessive supply so the prices had to go down.

Consequently, borrowers had mortgages that were significantly higher than what there house was worth. As a result, the investors simply couldn’t afford paying for their loans any longer, however, ultimately, the banks had still given out loans and needed money back from their investors, but since they weren’t receiving their money back many of them had to declare bankruptcy subsequently leading to heavily losses for both investors and banks alike causing the economy to go spiralling downwards.

To conclude, although there were a variety of factors contributing to the financial crisis it can be summarised due to: increased borrowing by investors (and subsequent increased lending by banks), excessive risk taking by investors due to favourable conditions, simply not taking into account future implications of current investment and policy errors i.e. giving out too large loans.