The 2008 Financial Crisis is the worst economic disaster since the Great Depression of 1929. It had inflicted profound damage on US financial system and economy. From October 1, the S&P fell 251 points, losing 21.6% of its value in just nine days’ time. The financial market experienced the largest percentage drop in the history of Dow Jones Industrial Average during the week of October 6 to October 10. This was unprecedented in history and was worse than any single week in theGreat Depression. The crisis spread rapidly beyond US border and became a global crisis. (See also: The Asian Financial Crisis 1997 Explained)
The long-term implication of the crisis? Millions in America and all over the world has lost their homes. Jobs were lost, with 2.6 million total job losses in 2008, making the biggest annual loss since the end of World War II. Life savings of ordinary Americans fell to a fraction of its value. As of today, a large volume of troubled mortgages remained in place and there is still evidence of the aftermath of the crisis in the US as well as global economy. The crisis has uncovered fundamental flaws in the free market system and was a wake-up call to all.
The bubble in making
In March 2001, America went into recession following the bursting of the dot-com bubble. As an effort to save the economy, the federal fund’s rate was lowered 11 times, from 6.5% in May 2000 to 1.75% in December 2001. Low-interest rates and tax cut saved the economy from deeper recession, but only by replacing the dot-com bubble with another bubble, the housing bubble. The housing market prospered due to the high liquidity of the market and easy credit. There was excessive borrowing to fund the purchase of the house. The mortgages were repackaged into collateralized debt obligations (CDOs) which were sold to investors. These highly profitable mortgage-backed securities created demand for more mortgages, prompting the banks into making subprime loans. Subprime loans, which are also called NINA loans, are loans made to borrowers with low credit ratings (No Income, No Asset). These subprime mortgages which have the high risk of being defaulted were backed with credit default swap which insures the buyers against loan default. With that, the supposedly risky CDOs were transformed into AAA-rated products, which made them safe enough to be held by a pension fund. The ability to buy a house with no down payment fed the American dream but created a time bomb that could trigger the most devastating economic turmoil.
The bursting of bubble
The decline of house prices had resulted in the default on loans and devaluation of housing-related securities. When the mortgage market which was built upon the subprime mortgage collapse, so did the entire financial market. In September 2008, major entities in the US such as Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley either failed, buyout or bailout (BBC, 2008). Fannie Mae and Freddie Mac were taken over by the federal government and insurance giant like AIG failed to honour the swaps. In October 2008, the Emergency Economic Stabilization Act was signed into law following a $700 billion emergency bailout of the banking system.
The effects of the 2008 Financial Crisis
The crisis spread to other parts of the world due to the highly intertwined global financial market. US$ 2.5 trillion of government debt and troubled private assets were purchased by the Federal Reserve and European Central Bank, resulting in the largest liquidity injection into the credit market and the largest monetary policy action in world history. It had triggered the popping of real estate bubble in Spain and United Kingdom as well as the collapse of Iceland banking system. Other parts of the world were not spared from the onslaught of the crisis and suffered from the collapse in global demand. Developing countries suffered from the fall in remittances and capital inflow.
The impending doom?
Looking into factors that have contributed to the crisis, it is easy to notice its strange similarity to those happened in the past. Deregulated market awash in liquidity, low-interest rates and lax credit system was a toxic combination which could bring down the whole economy. It was a textbook case that was not only predictable but also predicted. Can we not notice that? Taking the word of Joseph E. Stiglitz, the greatest surprise about the 2008 economic crisis was that it came as a surprise to many. So perhaps the problem lies not in knowing whether the bubble will pop, but when it will pop. While many may have noticed the bubble that we lived in, few was able to leave the market just in time before the first domino started tumbling down in the housing market. The financial crisis of 2008 has reiterated the importance of regulation of the financial system.
Therefore, regulation such as the Dodd-Frank Wall Street Reform Act and the Basel III capital and liquidity standards which regulate the financial market need to be adopted to prevent the likelihood of a future economic crisis. As the boom and bust of the economic cycle continue, there is a chance that some new bubbles will replace the housing bubble, just as how the tech bubble was replaced by the housing bubble. The UN has warned of the impending crisis which may include huge debt defaults among developing countries in its annual report on Trade and Development. So, what is next? Have all the lessons we learnt from the past lay a foundation strong enough for the economy to avoid and withstand another major hit? We will see.
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[tw-toggle title=”References “]
BBC (2007). BBC NEWS | Business | Timeline: Sub-prime losses. [online] News.bbc.co.uk. Available at: http://news.bbc.co.uk/2/hi/business/7096845.stm [Accessed 4 Nov. 2016].
Goldman, D. (2016). Total 2008 job loss: 2.6 million – Jan. 9, 2009. [online] Money.cnn.com. Available at: http://money.cnn.com/2009/01/09/news/economy/jobs_december/ [Accessed 6 Nov. 2016].
Trade and Development Report. (2016). In: United Nations Conference on Trade and Development. [online] New York: United Nations Publication, p.218. Available at: http://unctad.org/en/PublicationsLibrary/tdr2016_en.pdf [Accessed 6 Nov. 2016].