The Global Financial Crisis Overview

Although multiple factors contributed to the Global Financial Crisis, many believe the overall cause was the lack of regulation within the financial industry. In the absence of strict control, banking institutions have greater latitudes to take unconventional risks in search of higher rewards. Competition among power brokers is always fierce and today’s corporate climate exudes the understanding that “consumer focused companies have the potential to push competitors out of the market” (Thomas, 2016). Nevertheless, in the lax regulatory environment prior to 2008, the opportunity to travel down unsecured profit-seeking paths was too readily available for professionals and heads of corporations that were not guided by sound personal morals and ethics. Such was the case that led to the GFC, subprime mortgages were offered to high-risk homeowners, despite the inherent risks associated with lending money to a population likely to default on notes associated with flexible escalating interest rates. When faced with ever-increasing rates, most were unable to make the required payments, which led to vast numbers of homeowners defaulting on their mortgages. “In the late 1990s and early 2000s, there was an explosion in the issuance of bonds backed by mortgages, also known as mortgage-backed securities (MBS). The reason for this was the use of securitization” (Financial Banking Crisis 2008—Detailed Overview, n.d.). A mortgage-backed security (MBS) is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them and securitization is the pooling of debt and then issuing assets based upon that debt. The merging of different mortgages reduced the risk, and these assets were deemed very safe, but in reality, the majority of the mortgages being securitized were of poor quality, which is referred to as subprime mortgages. The repackaging of the subprime mortgages was also known as collateralized debt obligations (CDO’s). CDO’s are financial tools that banks use to repackage individual loans into a product which is then sold to investors on the secondary market. These practices created a vulnerability in the market that yielded catastrophic results soon after the first tremors of financial instability were sustained.
Another critical component in the destabilization of the weak foundation was the fact that the rating agencies overestimated the value of the subprime mortgages. Essentially, Triple A-rated debt was bundled with junk debt and misrepresented for sale as A’s. The credit rating agencies overvalued the mortgage-backed securities which eventually lead U.S. and global banks to spend more than they could account for, borrowing vast amounts of money at low rates in the short term to fund their investments in mortgage-backed securities (Uslu, 2017). After issuing extensive quantities of subprime mortgages, the rise in home value ultimately led to “the U.S. household debt exceeding disposable income by one-third in 2006 and remained at that level in 2007. The borrowing capacity of U.S. households eroded gradually, and the default risk of the household sector (the largest contributor to the U.S. GDP) became a serious, grossly underestimated problem”

Unfortunately, the risky decisions were not solely focused on the housing market and extended well into other financial realms. Simultaneously, the Federal Reserve System (The Fed), the central banking system of the United States of America, decided to increase the Federal interest rate for the first time since May of 2000. The increase in the rate came as a result of inflation, which was under two percent. The Fed backed these claims by stating how there had been a steady improvement in the labor market conditions. However, the Fed did not realize how the increase in interest rates would attribute to the rise in the mortgage default rate in 2006 and 2007. The combination of the subprime mortgages and rise in the interest rates set forth the path of “foreclosures on housing properties in the U.S. rose by nearly 1.3 million in 2007, up 79 percent from 2006” (Orlowski, n.d.). Once people started defaulting on their payments, the theoretical “chain” of debt broke, and real GDP took a hard hit.
As a result, investors lost trust and confidence in financial institutions and began to withdraw funds and sell off large amounts of assets and securities. Hence, the collapse of the overall financial structure in the U.S. unfolded, credit markets ceased, and a significant sell-off was unavoidable. Both financial institutions and individuals across the United States, could not obtain necessary credit during the peak of the financial crisis. Trusted investment banking institutions such as Lehman Brothers, Bear Stearns, and Merrill Lynch lost billions and ultimately saw their own demise (Smith, 2011). “Companies with value-based decision-making behavior and consumer transparency commonly sustain high levels of customer loyalty, consumer trust, and long term success” (Thomas, 2016). Clearly, these former industry leaders abandoned this notion in pursuit of easy money and paid dearly in abandoning time tested business fundamentals. As a result of their collective unscrupulous efforts, unemployment rates skyrocketed, and hopelessness crept into the psyche of many, worsening the economic downturn to an unexpected reality. Schoen explains the severity of an increase in the unemployment rates as “The disastrous effects included serious and long-lasting unemployment and huge declines in the gross domestic product” (Schoen,
2017). He further clarified the harsh reality of the loss of prosperity by stating that “On average, the economy shed 46,000 jobs per month in the first quarter of 2008, a scary 651,000 over the last quarter, and horrifying 780,000 in the first quarter of 2009. Just under 8.8 million jobs were lost during a period when the economy should have added about 3.1 million jobs to accommodate ordinary labor force growth” (Schoen, 2017). The numbers and statistics painted a clear image of the devastating impact that the financial crisis had on many households. Unfortunately, the unemployment rate was not the only contributor affecting everyone’s financial status; the stock market also took massive hits during this time. The general unease about the global mortgage and credit markets led to the stock market crash. On October 9th, 2007, the Dow hit its pre-recession high and closed at $14,164.43. By March 5th, 2009, it had dropped more than 50 percent to
$6,594.44 (Analysis & Amadeo, n.d.). It was then that regulators and policymakers realized the action was needed to implement strategies to recover and prevent the steps that led to the downfall of the global economy and help prevent future decline.