The Financial Crisis of 2007

The financial crisis of 2007–2008, also known as the global financial crisis (GFC), also called the subprime mortgage crisis, was a severe worldwide financial crisis. Excessive risk-taking by banks combined with the bursting of the United States housing bubble caused the values of securities tied to U.S. real estate to plummet, damaging financial institutions globally, culminating with the bankruptcy of Lehman Brothers on September 15, 2008, and an international banking crisis. The crisis sparked the Great Recession, which was the most severe global recession since the Great Depression. It was also followed by the European debt crisis, which began with a deficit in Greece in late 2009, and the 2008–2011 Icelandic financial crisis, which involved the bank failure of all three of the major banks in Iceland and, relative to the size of its economy, was the largest economic collapse suffered by any country in economic history.

Understanding the crisis of 2007-08

The massive flow of savings from the surplus countries to the deficit countries lowered global interest rates by encouraging reckless investment into risky housing-related assets such as subprime mortgages. These macroeconomic imbalances affected financial interactions. Apart from this, loose monetary policy in the U. S left the banks with a decrease in net interest margins for the banks, decreasing their profits. The bloated financial sector, flawed belief in efficient markets, greedy bankers, incompetent rating agencies are considered being some other causes for the financial crisis. However, the failure of regulation on the banks’ parts was one of the major reasons behind the crisis. They allowed banks to extraordinarily high levels of debt in relation to equity capital. Also, investment by banks in the advanced economies in complex assets called “securitized” assets (securities derived from sub-prime loans or the housing loans of relatively higher risk) added to the vulnerability of the financial infrastructure. When debt defaults increased with interest rates while income growth remained subdued, the world became more vulnerable to the financial crisis. Banks’ dependence on short-term, riskier loans was not just an American problem but a problem for large chunks of the global banking system. It affected banks in Europe and some in Asia. Further, the failure of banking systems around the world was aggravated by the fiscal and monetary expansion. Losing jobs and output has been enormous.

We believe the 2007 financial crisis to have been caused by some of these changes in the financial sector landscape. the reckless behaviour of financial institutions played a key role. The classic explanation of the financial crisis is that excesses cause them and more frequently by monetary excesses, which leads to a boom and an inevitable bust. In 2007 also, we had a housing boom and bust, which led to financial turmoil in the US and around the globe (Taylor, 2008, p. 1). Rajan posits that the common cause of the 2007 financial crisis was the ‗cyclical euphoria ‘born in some ways from the previous financial crisis that swept through the EMEs in the late 1990s. Responding to these crisis episodes, EMEs became very cautious about external borrowing to finance domestic demand. Formerly net absorbers of financial capital from the rest of the world, most of these EMEs became net exporters of financial capital (Rajan, 2009, p. 397). These developments coincided with the savings of typical exporters (Germany and Japan) and resulted in a ‗global saving glut‘ 30 as referred by Bernanke (Bernanke, 2005). However, Norgren (2010) believe that there are several factors that combined to make this one the most severe crisis since the Great Depression of the 1930s; these include macroeconomic problems, failures in financial markets and shortcomings in implementing the regulatory policy. We can find some causes of the crisis in the macroeconomic policies of the past years. However, failures in the financial system, particularly in the US, were at the root of the problem.

Causes

  1. Imprudent Mortgage Lending

2. Housing Bubble

3. Global Imbalances

4. Securitization

5. Lack of Transparency and Accountability in Mortgage Finance

6. Rating Agencies

7. Mark-to-Market Accounting

8. Shadow Banking System 

9. Non-Bank Runs

10. Off-Balance Sheet Finance

11. Government-Mandated Subprime Lending

12. Failure of Risk Management Systems 

13. Financial Innovation

14. Complexity

15. Human Frailty

16. Bad Computer Models

17. Excessive Leverage

18. Relaxed Regulation of Leverage

19. Credit Default Swaps (CDS)

20. Over-the-Counter Derivatives 

21. Fragmented Regulation

22. No Systemic Risk Regulator

23. Short-term Incentives

24. Tail Risk

25. Black Swan Theory

Theories of instability

  1. Debt and financial fragility theory.
  2. Monetarist views.
  3. Uncertainty
  4. Disaster myopia and credit rationing
  5. Asymmetric information and agency costs
  6. Bank runs
  7. Industrial aspects

Prediction by the economists about the crisis

Economists, particularly followers of mainstream economics, mostly failed to predict the crisis. The The Wharton School of the University of Pennsylvania’s online business journal examined why economists failed to predict a major global financial crisis and concluded that economists used mathematical models that failed to account for the critical roles that banks and other financial institutions, as opposed to producers and consumers of goods and services, play in the economy.

Popular articles published in the mass media have led the public to believe that most economists have failed in their obligation to predict the financial crisis. For example, an article in The New York Times noted that economist Nouriel Roubini warned of such crisis as early as September 2006, and stated that the profession of economics is bad at predicting recessions.

According to The Guardian, Roubini was ridiculed for predicting a collapse of the housing market and worldwide recession, while The New York Times labelled him “Dr Doom”.

Indy Mac

The first visible institution to run into trouble in the United States was the Southern California–based IndyMac, a spin-off of Countrywide Financial. Before its failure, IndyMac Bank was the largest savings and loan association in the Los Angeles market and the seventh-largest mortgage loan originator in the United States. The failure of IndyMac Bank on July 11, 2008, was the fourth-largest bank failure in the United States history until the crisis precipitated even larger failures and the second largest failure of a regulated thrift.IndyMac Bank’s parent corporation was IndyMac Bancorp until the FDIC seized IndyMac Bank. IndyMac Bancorp filed for Chapter 7 bankruptcy in July 2008.

Effects of the crisis

In 2012 the St. Louis Federal Reserve Bank estimated that during the financial crisis the net worth of American households had declined by about $17 trillion in inflation-adjusted terms, a loss of 26 per cent. In a 2018 study, the Federal Reserve Bank of San Francisco found ten years after the start of the financial crisis, the country’s gross domestic product was approximately 7 per cent lower than it would have been had the crisis not occurred, representing a loss of $70,000 in lifetime income for every American. Approximately 7.5 million jobs lost between 2007 and 2009, representing a doubling of the unemployment rate, which stood at nearly 10 per cent in 2010. Although the economy slowly added jobs after the start of the recovery in 2009, reducing the unemployment rate to 3.9 per cent in 2018, many of the added jobs were lower-paying and less secure than the ones that had been lost.

Conclusion

The Global Financial crisis of 2007 and 2008 was a misfortune that might have been totally dodged. Misfortune influenced economies around the whole world. A significant part of the world’s economy keeps on enduring the enduring impacts of the Global Financial Crisis of 2007 and 2008 today. Media telecasters totally bombed the whole world, in light of the fact that the reports never ask the intense questions constraining market analyst to deliver proof on the side of the bogus case of a land bubble that never existed.

It is very upsetting; such a critical mistake could proceed however long it did. It is basic to increase an understanding of how such a misfortune might have occurred when a plenitude of data is accessible at the fingertips. Exercises gain from the errors made which caused the Global Financial Crisis of 2007 and 2008 can forestall another crisis later on.

The specialist requires extra investigations zeroed in on the understanding element that added to the financial crisis. Future examination pointed toward increasing an understanding of the genuine nature of the Global Financial Crisis of 2007 and 2008 is required to re-examine the writing, in view of new data revealed in ongoing investigations.

Frequently Asked Questions (FAQs)

  1. What are the Financial Crises?
  2. Financial crises are caused by what reasons?
  3. How Bank and Financial crises are interlinked?
  4. Consequences after the Financial crises?

References

  1. Will Kenton, Financial Crisis, INVESTOPEDIA (April 26, 2020, 05:51 P.M.)
  2. https://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932008
  3. https://www.drishtiias.com/daily-updates/daily-news-editorials/understanding-financial=-crisis-of-2007-08
  4. https://tel.archives-ouvertes.fr/tel-00987627/document
  5. https://www.researchgate.net/publication/251637568_The_Global_Financial_Crises_of_2007-2010_and_the_future_of_capitalism
  6. https://knowledge.wharton.upenn.edu/article/why-economists-failed-to-predict-the-financial-crisis/
  7.   Mihm, Stephen (August 15, 2008). “Dr. Doom”. New York Times Magazine.
  8. Brockes, Emma (January 24, 2009). “He Told Us So”. The Guardian. London.
  9. https://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932008#IndyMac
  10. https://www.britannica.com/event/financial-crisis-of-2007-2008/Effects-and-aftermath-of-the-crisis

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