Macro Moves

Financial Crisis 2008 : Causes, Cost and the after Effect

Created on 05 Oct 2020

Wraps up in 6 Min

Read by 42.7k people

Updated on 09 Mar 2024

The gold prices are falling, and the markets are crashing! While the statement is absolutely unreal, just the thought of it would have been enough to you a heart attack, wouldn't it? We would prefer to be destroyed by the snap of Thanos than getting stuck in such a situation, right?

Would you believe if someone were to say that a similar situation challenged some of the top global economies in 2008? Yes, we are talking about the financial crisis of 2008, an event which took the financial system of America and other major economies by storm, sparing none. 

The recent economic crisis caused by the COVID-19 pandemic, brought the topic back to discussions, with major economists and professionals comparing the current scene with the financial crisis 2008. Hence, navigating through the various reasons and aftermath effects triggered by the financial crisis becomes crucial and demanding.

Let's get into it.

The Start of the Grave Fall

Loans are a crucial part of any financial system. However, you need a specific credit rating to acquire them. As far as India is concerned, you need a CIBIL score of 700 or more to get your loan sanctioned without any hassle. Similarly, in the USA, you need the FICO rating of more than 640 to acquire a loan. So what was the problem here?

The problem started with the action of subprime loans. The US banks came up with the idea of lending housing loans to those individuals whose ratings were below the benchmark rating of 640. However, to compensate for the risk taken, they charged a higher rate of interest. These loans were then bundled with good ones and were issued as mortgage-backed securities (MBS). To be precise, it's like mixing good vegetables with the rotten ones. 

The rating agencies like MOODY's rated them with a AAA, which ultimately made them an attractive investment for investors who assumed it to be free from the risk of default. Further, the housing sector was at its peak during early 2005, making investors move huge amounts of money into these derivatives. This included a large number of banks, private lending institutions, and other worldwide financial institutions investing in them.  

Hedge funds institutions, mutual fund companies, and various other pension fund institutions also invested in these swaps. And the ownership of houses rose to more than 69%. However, no one could predict that great destruction was in process. 

What was the cause of the 2008 financial crisis?

As banks could pass on the risk to the investors, they were happily sanctioning loans to people without proper documentation and adequate ratings. No one worried about the consequences. While all seemed like rainbows and unicorns for a while, soon reality demanded its way back. 

The prices of the housing sector saw a fall at the beginning of 2005, and the banks witnessed a lot of their borrowers defaulting the repayment. 

Would you give poison to an already dying person? But what the banks did was something like that. Rather than coming up with some reliable solution, they decided to increase the interest rates further. They thought that they could offset the losses by charging higher rates on the ones that make regular payments or at least make a conscious effort to pay. The rates were increased from 2.25% to 5.25%. Burdened by massive interest rates, the defaults only increased. 

While the banks promised safety and security with a higher return, their action did not project the same. And by the end of 2007, the American economy officially entered the recession. 

The Domino Effect

The books of the banks showed huge lending and falling repayment. Following which the banks witnessed a severe liquidity crunch and a lot of them filed for bankruptcy. As the fear brewed up, the banks stopped lending to one another, thus affecting the interbank money market. 

They all searched for funds outside, and the Northern Bank of London came to their rescue. But it did not last long as the bank was nationalized by the British government, chopping off the help offered.

This caused the collapse of some of the major financial institutions of Wall Street. The Swiss bank UBS was one of the first to declare bankruptcy and showed a loss of more than 3 billion dollars. The lack of liquidity and huge losses pushed Bear Stearns, Fannie Mae and Freddie mac to the edge of the cliff. However, the government of America was swift and rescued them from the brink of death.

Following this, the Lehman Brothers declared bankruptcy leaving the stock markets to fall drastically. For investors who believed that the US government would rescue them, it was nothing more than a false belief. 

The crisis kick-started with investors selling their stakes in huge amounts. And by the end of 2008, the entire financial system of America was in utter chaos.

Cost of the 2008 Financial Crisis

The financial crisis 2008, as expected, affected after everything that was even remotely dependent upon the US economy. The financial crisis 2008, caused the US economy roughly around $22.8 trillion. In other words, it was approximately $72000 per American citizen. It's impacted the output of the country by $13 trillion. The country lost about $5 trillion in terms of GDP over the next few years.

 About 20 million people were affected directly or indirectly by the crisis. British banks lost approximately £90 billion in just a single day. And the ill effects can be added to this list. Hence, the government was forced to interfere in the matter and to sort the situation out. Want to know how the American government reacted? Read further to find out. 

The Troubled Asset Relief Program

The American treasury came forward to address the crisis. They did this by purchasing mortgage-backed security (MBS) from the companies, in a view to reduce their losses. Drafted by Henry Paulson and brought into effect by George W. Bush, the plan aimed to stabilize the money market and secondary market by injecting liquidity into the system. 

The program spent more than $247 billion to stabilize the banking systems. They bought shares of JP Morgan, Citi Group, and Wells Fargo at an interest of 5%. Also, $79.2 billion was spent on bailing out the auto sector, whose stock went on a free fall and $67.8 billion was spent on nationalizing the AIG sector. 

The policy did a huge deal in reducing the burden that was placed on the economy. But critics still argue upon its efficiency and claim that it failed to shed light upon the housing sector. 

The Aftermath of the Financial Crisis 2008

The housing prices saw a steep fall of more than 31.8%. Though the US economy came out of recession after 2 years, the impact was still prevalent. The unemployment saw an all-time high and stayed more than 9% even after two years. 

A huge part of the population lost their money, homes and livelihood. Most of them even lost their pension money. In short, this crisis proved to be worse than the great depression.

India, at that time, was less dependent on the US economy and therefore was less exposed to its negative side. However, it wasn't completely guarded against the huge bomb that took the entire financial market of the US into dust. 

The GDP of India fell from 9% to 7.8% in 2008. Approximately $12 billion worth of investors withdrew from the stock markets, and they're a huge fall was witnessed. Also, the trade and fiscal deficit were hurt badly. But the then- Indian government was prompt in answering the crisis. 
For more information on the Financial crisis of 2008, you refer to this video on Youtube.

To Sum Up

History is a good teacher. And the financial crisis of 2008 was good in teaching the world how bad a situation can get if even a small thing goes wrong. Such a situation is unlikely to happen again, as various countries have tried to formulate their financial planning based on the lessons which were taught by the 2008 crisis.

However, there are predictions that the student loan sector might be the next big financial bubble in the process. Will, it really burst or is it just a myth? We will have to wait and watch, and of course, be prepared. 

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Ayushi Upadhyay

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A Keen Learner. Tiny, brainy, and studious, this quiet one stays in her zone until she pops. And once she does, boy, are her comebacks snappy! There is no financial question that she can't answer through her magical blog-writing. 

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