The 2008 Financial Crisis, a.k.a. The Great Recession. Describe what you observed about the 2008 Financial Crisis and its impact on the economy by using economic vocabulary and models to help describe your thinking.

 

Video Clip & Links to Additional Resources: Federal Reserve: Crisis and Response Links to an external site.

The 2008 financial crisis was the most worst economic downturn that the global economy has ever faced since the Great Depression of 1929. This financial crisis led to the Great Recession which continued for two years. It has permanently alter the US financial system and due to this, there were loss of millions of jobs, stock market crashed and the prices of assets fell drastically.

The 2008 financial crisis was the most worst economic downturn that the global economy has ever faced since the Great Depression of 1929. This financial crisis led to the Great Recession which continued for two years. It has permanently alter the US financial system and due to this, there were loss of millions of jobs, stock market crashed and the prices of assets fell drastically.

The main forces that led to the financial crisis are as follows

·      In 2001, there was a mild recession and to overcome from this recession Federal Reserve decreased its funds rate 11 times in that year from 6.5% to 1.75%. This decreased the cost of borrowing and expanded the bank's ability to advance loans. This encouraged sub-prime lending and consumers thought that it was the best time to buy their own houses and build your wealth. The demand and price of houses was increasing continuously which resulted in creation of housing price bubble.

·      In 1980s there were change of bank rules that allowed mortgage loans with facilities of balloon payments and adjustable interest rates. As the prices of houses were increasing at that time lenders could protect themselves by refinancing or selling their homes at high prices. If any lender defaulted then bank would sell the mortgage at a higher amount then the loan amount and this further encouraged sub-prime lending by banks.

·      Securitization- In this process banks would bundled their sub-prime mortgage and sold them as bonds or securities in the financial markets. These securities were known as mortgage-backed securities. These became very popular and their value increased in the market continuously. In 2000s, many banks and investment firms had large MSBs in their portfolios.

·      In 2000, US government announced full freedom in the financial markets and there were no regulation on the investors in the financial market. US banks sold mortgage backed securities to insurance firm which sold it to other investors and this led to formation of new financial derivative known as Collateralised Debt Obligation (CDO). These became very popular in US financial market and to meet the high demand of these CDOs, they were now filled with high default risk mortgage backed securities.

In 2004, Federal Reserve increased its funds rate from to 5.25% that led to various defaults of sub-prime lenders. Housing market has reached to its highest point and the prices of houses began to fall and for the first time in 2005 there was a decrease in price of houses. The house prices continued to fall and the values of mortgage and mortgage-backed securities was also decreasing. Many firms were now in the verge of bankruptcy and the financial market was ready to explode.

The consequence of 2008 financial crisis are as follows:

• Many people had to leave their homes and foreclosures increased in 2006 and 2007. Real Estate sector was in trouble as there was no demand for houses now.
• Large Mortgage lending companies like Fannie Mac and Freddy Mac were bankrupted. The entire banking industry was effected and Investment Banks lost their liquidity. Large amount of CODs failed and the biggest insurance company, American International Group was not able to pay its debt obligations.
• Many small investors were in trouble as stock market crashed and many people lost their lifetime savings in CODs.
• In the year of 2008, the decrease in US's GDP was around $648 billion, US's government spent $73 billion in relief packages, $3.4 trillion was lost in the real estate value, fall in stock values was around $7.4 trillion and there was loss of more than 5.5 million jobs in U.S.
• The impact of 2008 Financial crisis was spread globally because of the increased interdependence among the nations. These CODs and MSBs were bought by many other countries especially Europe. Many banks and mortgage lenders in Europe filed for Bankruptcy and there was first Bank Run in UK. There was decrease in demand for exports from U.S. which effected the economy of China and Japan. Unemployment rates in China, Japan, Europe and rest of the world increased and there was slow economic growth in every sector of the economy.