Revisiting the Global Financial Crisis

In February, we reported that the United Kingdom and Japan officially slipped into recession as the gross domestic product (GDP) of both the countries shrank for the last two quarters in 2023 in a row.

The news spread a contagious disquiet in the financial markets as it brought back memories of the global financial crisis (GFC) that occurred during the late 2000s.

With the US housing bubble bursting, the ensuing credit crunch led to the collapse of the financial sector across several parts of the globe.

Even though the current recession in these countries is a pale shadow of the GFC, the dramatic phenomenon still casts a long shadow on the financial markets.

Today, we will revisit the global financial crisis that engulfed nearly all the major economies in the world during 2007-09.

Defining the Global Financial Crisis

Global financial crisis (GFC) or the Great Recession is the period of global economic downturn during 2007-09.

An economy is officially considered to be in recession when it contracts for two consecutive financial quarters.

• During the GFC, the US slipped into recession in December 2007 which lasted till June 2009.
• The GDP of the country dropped 4.3% during this period.
• Banks and financial institutions declared bankruptcy, millions lost their permanent jobs and the standard of living, in general, declined.
• Lasting 18 months, the GFC was the longest recession since the Great Depression that occurred during 1929-421.

How It All Began…

Even though not even two decades have passed since the GFC, a lot of people, young people in particular, aren’t quite aware of the gravity of the crisis.

Let’s begin. 
 

• At the dawn of the 21st century, the US economy tanked in the wake of the 9/11 terror attack and the Dotcom bubble implosion. 

  
   

• In response, the Federal Reserve significantly reduced fund rates to around 1% for the next few years to stimulate the economy. 

  
   

• Low fund rates allowed banks to offer housing loans at low mortgage rates. 

  
   

• It led to a huge boom in the housing market, given that the government was also encouraging more and more people to own houses at the time.

   

• As the housing sector bloomed during the early 2000s, banks began offering a variety of innovative complex financial instruments to large investment banks. 
   

   

• These instruments were mortgage-backed securities (MBSs), collateralised debt obligations (CDOs) and credit default swaps (CDSs) which yielded significantly better returns than those offered by traditional investments.

   

Let's quickly explain these terms:

1. Similar to a bond, an MBS consists of an array of home loans and other real estate debt bought from the banks that issued them. Investors in an MBS receive periodic payments, similar to bond payments. 

    

2. A CDO is a financial derivative that is backed by a pool of loans (home loans in this case). A CDO is considered a viable tool for diversifying risk and creating more liquid capital for investment banks. 

    

3. A CDS is a financial derivative that allows an investor to swap or transfer their credit risk with that of another investor. In a CDS, the buyer pays an ongoing premium similar to an insurance policy premiums. In exchange, the seller agrees to pay the security's value and interest payments if a default occurs.

• Since these instruments yielded extraordinary returns, Wall Street asked banks to sell them more of these instruments. 
   
• However, the banks realised it wasn't possible to offer any more mortgage loans as the housing segment was saturated. 
   
• But due to the desire for more profits, the banks began offering subprime mortgages at adjustable rates. 
   
• These loans were offered to low-income and less-educated borrowers who had poor credit scores and unstable incomes. 
   
• Low interest rates in the beginning, coupled with the rising prices of houses, attracted borrowers like bees to honey. 
   
• The banks were then able to sell more and more loans to large sharks on Wall Street. 
   
• In turn, these large investment banks bundled and packaged them into more and more MBSs and CDOs.

All of these complex factors contributed to creating a housing price bubble in the early 2000s which burst in the later years of the decade.

Let's see how: 
 

• The Fed began to hike fund rates in mid-2004. It continued hiking the rates from ~1.5% to ~5% between 2004 and 2007. 

  
   

• In turn, banks began hiking the interest rates of existing and new house loans. 

  
   

• Those poorly educated folks with low-income weren't made aware of the adjustable nature of the interest rates. They believed that interest rates would stay the same forever. 

  
   

• Homeownership in the US hit its high in 2004, reaching 69.2%. 

  
   

• But it quickly reached a saturation point. Two years later, house prices began to decline in 2006. 

  
   

• So, house owners saw the prices of their houses declining while they were now paying more interest rates. In short, they were paying more for their houses in comparison to their current worth. 

  
   

• This is how the housing price bubble burst. 

  
   

• By 2007, most of these subprime borrowers decided to stop paying their monthly interests and began to default on their loans. 

  
   

• Banks were left with no choice other than taking these homes and selling them at market prices with a huge loss.

The Ultimate Collapse

As the housing price bubble burst, a lot of subprime lenders began to file for bankruptcy. More than 25 of such predatory subprime lenders collapsed during this period.

The value of the above-mentioned financial instruments such as MBSs, CDOs, CDSs etc. also started plummeting.  

Consequently, these interconnected financial institutions began recording huge losses and quickly collapsed.

• New Century Financial declared bankruptcy in 2007.
• The same year, Bear Stearns failed which was later acquired by JP Morgan Chase.

By the end of 2007, the US officially slipped into recession. 
 

• The next year, the Treasury nationalised the country's two biggest subprime lenders, Fannie Mae and Freddie Mac to cover their debts worth $1.6 trillion. 

  
   

• In September 2008, the Wall Street giant Lehman Brothers declared bankruptcy. It was the largest bankruptcy in the history of modern America.

All the government departments in the US, such as the Congress, the White House, the Fed, and the Treasury failed to stop the house of cards that was collapsing.

Recommended Read: Revisiting the Great Depression 
 

Europe wasn’t spared either.

• Northern Rock, a UK bank engaged in mortgages, became the first British bank in 150 years to fail due to a bank run. It got nationalised in the process. 

  
   

• The Swiss bank UBS became the first major bank to announce losses worth $3.4 billion due to similar failure in mortgage investments.

So, How Bad Was It?

The GFC affected nearly all the economic areas of the US economy.

• As the immediate result of the housing crisis, around 3.8 million houses were taken away and sold by the banks.
• More than 8.7 million people in the US lost their jobs. Unemployment rate doubled to 10% during this recession.
• Households in the US lost $19 trillion in net worth, a loss of 26%.
• Real GDP of the country declined by 4.5% during the recession years.

Government Attempts to Rescue the Economy

As the crisis unfolded, the US government intervened by putting in place different measures.

The Congress passed the Emergency Economic Stabilization Act (EESA) in 2008.

• A bailout measure, it authorised the Treasury to buy up to $700 billion in troubled assets, though the figure was later reduced to $475 billion.

The EESA led to the Troubled Assets Relief Program (TARP) being established.

• TARP disbursed $443 billion in the form of investments, loans, and payouts.
• $390 billion out of this amount was repaid to the Treasury.
• The Treasury also earned $52.5 billion on those investments and loans.
• Overall, the TARP helped the Treasury gain a profit of $110 billion.

In 2009, the Congress passed the American Recovery and Reinvestment Act (ARRA).

• ARRA was a fiscal stimulus worth around $800 billion that included a wide range of federal spending initiatives.
• These included reviving the economy, job creation, keeping small businesses open, and relieving the tax burden.

In 2010, the Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act.

• It strengthened the government control over the financial markets.  
• Remember that it was lax regulation of the market that led to such unfettered misadventures in the housing market.
• It also pushed back against unethical practices targeting vulnerable customers.  
• Unethical practices like predatory mortgage lending had led to the housing bubble in the first place.

Did Things Go Back to Normal?

While it certainly took some time, things started to fall right back in place after these interventions proved to be useful. The GFC which began in December 2007 ended in June 2009.

Real GDP had hit the rock bottom during this period of recession.

• It finally regained its pre-recession peak in Q2 2011.

   

Liquidity helped the financial markets recover over the years.

• Dow Jones Industrial Average (DJIA, an average of 30 large companies on the New York Stock Exchange) lost over 50% of its value when it slipped to 6,469.95 in March 2009.

   

It started recovering in March 2009, though it could not surpass its 2007 high before March 2013.

Jobs emerged even though they were low-paying ones.

• Unemployment rate didn’t return to pre-recession level, i.e. 5%, until 2015.
• Household incomes didn’t recover to pre-recession level until 2016.

GFC Timeline...

Source: Pew Research Centre

In Short...

Global financial crisis or the Great Recession (2007-09) is the most devastating economic crises of the 21st century so far.

It lasted from December 2007 to June 2009 as the GDP of the US sank 4.3% during this period. The rest of the world was not spared either as several economies across Europe and Asia suffered economic doom.

Several financial institutions declared bankruptcy as millions of households witnessed a significant decline in their living standards for those years.

It wasn't before 2010 that things slowly started to get a bit normal. There were jobs but they didn't pay much.

Unemployment rate and household incomes didn’t return to pre-recession level until 2015-16.

In many ways, we are yet to recover from the long-term effects of the GFC as it impacted the markets across the globe for worse.