The Financial crisis of 2008 or the Great Recession is the biggest economic event in the world after the Great Depression of the 1930s. The first part of the article explains the causes of the financial crisis in a very simplified way.
What is a financial crisis?
- A financial crisis is a crisis which severely affects the functioning of the financial system. Financial system consists of banks, mutual funds, investment banks, pension funds etc.
- In a financial crisis, the financial assets (like shares) lose a part of its nominal value.
What was the immediate trigger of the financial crisis of 2008?
- The immediate cause of the crisis of the crisis was the burst of the housing bubble in the United States.
What is a housing bubble?
- In economic terms, a bubble is when the price of an asset increases above their true intrinsic or fundamental value.
- Example: If the intrinsic/ fundamental value of a pen is Rs. 20, but due to some reasons the price increases to Rs. 20000, it is a bubble
- In other words, a bubble is when the price of the asset does not correspond to its fundamental value.
- As children, we all have made soap bubbles and know that they eventually burst.
- From the 1990s until February 2007, prices of houses in the US increased by a staggering 130 % This was a housing bubble.
- The bubble eventually had to burst.
Why did the price of houses in the USA increase? What was the cause of the Housing bubble?
The price of an asset is determined by the forces of demand and supply. The reasons for the increase in price were:
- Low-interest rates: During the period from 2000 to 2003, interest rates in the USA were lowered from 6.5 % to 1 %. It was done in response to the Dot-com bubble burst in 2000 and the Sept 2001 attack at the World Trade Centre. Due to low-interest rates, people began to take more loans to buy homes (Home mortgage loan). The demand for houses increased and hence its price.
- Another reason for low interest rates in the US was the global saving glut: Savings flowed from China, Japan, Germany & the oil exporting middle-eastern countries into the US economy as the USA was considered to be a safe investment. This increase in the supply of funds in the US led to a decline in interest rates. People borrowed more to buy homes and the prices increases
- Government policies to encourage home loans like income tax deductibility of interest paid on home mortgages also led to an increase in demand for houses
- The Great Moderation (1980s to 2007): The period of 1980s to 2007 in the US was a period of low inflation, low interest rates and stable growth. Due to the stability of the economy, people became complacent and they were willing to take up more risks than ever. Therefore, lenders lent more and households borrowed more.
Why was the housing bubble disastrous for the economy?
- The housing bubble led to a decline in mortgage standards. (Home mortgage loan is a loan in which you take a loan to buy a house and keep the house itself as a mortgage/ collateral. Mortgage means ‘girvi’ in Hindi) Financial institutions (banks) began to lend to sub-prime borrowers (subprime borrowers are the borrowers with low credit worthiness)
- There was an assumption that prices will always rise and, if the sub-prime borrowers are unable to repay their loans, banks can sell the houses and recover the loan.
- Reckless lending by banks brought more people into the housing market.
- House prices rose further and US households became leveraged.(Household leveraged means they borrowed more relative to their income)
But, bubble burst eventually (prices came crashing down)
By September 2007, prices declined by 25 %. The reasons for the decline were:
- Housing market became saturated. Everyone who needed a house had one. So, there was a decrease in demand for houses.
- Fed raised interest rates from June 2004 to June 2006. Home loans became expensive (reversed its earlier policy of lower interest rates)
What were the consequences of the burst?
As prices of houses fell, people began to default on their home mortgage loan. As their homes were worth less now (due to reduction in price), and no longer had the incentive to repay their loans which became very expensive (due to increase in interest rates)
Widespread defaults resulted in Foreclosure. Foreclosure means banks had to sell off the houses kept as collateral/ mortgage to recover the loans.
But, as house prices were low, banks had to suffer losses on the mortgage home loans as they could not recover the loans fully
The rise in foreclosure pushed down prices further as the supply of houses in the market increased.
This was essentially a sub-prime mortgage crisis
The borrowers could not refinance the loan as the interest rates were increased by the Federal Reserve in 2007. The standard mortgage in the US has a maturity of 30 years and has a fixed interest rate.
But, in Adjustable Rates Mortgages which grew in popularity, the initial interest rates are too low (1 %) and after 2 or 3 years, it reflects the market interest rates. They are also known as teaser loans.
After 2 years, the borrowers refinance into a standard mortgage. Refinance means taking a new loan to discharge an existing loan. But, borrowers could not refinance as the market interest rates increased due to increase in interest rates and they defaulted on the loan
This bubble could have been restricted to the housing market in the United States. But, it spread to the financial markets and to the whole of the world and became a global financial crisis.
We have explained the causes in the second part of the article.(/the-financial-crisis-2008-explained-part-2/)
You can also check out our article on the Greece Crisis (/the-greece-debt-crisis-explained/)