When asked about your favourite movie on the matter of economics, the answer for most of us would be The Big Short, directed by Adam McKay and adapted from a non-fiction book of the same name by Michael Lewis. This thrilling and exciting movie, however, is based on the most famous financial crisis of all time: the financial crisis of 2008.
Oftentimes, when economic downturns occur, they require a special name to characterise them — such as the Great Depression of 1929 or the OPEC Oil Price shock of 1973. But the 2008 crisis requires no such adjective about its size. This article seeks to break down this event into a digestible read so that you can understand one of the world’s greatest economic events.
The 2008 crisis was the greatest jolt to the financial system since the Great Depression and pushed all of our financial systems to the brink of collapse. In September 2008, one of the world’s largest financial institutions declared bankruptcy and that is when it began. But what caused this financial crash?
The biggest trigger to the financial crisis was the burst of the housing bubble in the United States. As explained in the last Economic Byte, a bubble is where the price of an asset increases above its fundamental value. Imagine a water bottle that, by market equilibrium, is truly priced at Rs 300, but for some reason is valued at Rs 300,000. That is an asset bubble. From the 90s up until the 2000s, the prices of houses in the USA increased by 130%, as can be seen in the graph above. The reasons for the pricing bubble were:
- Low interest rates during the period: Rates of interest were lowered from 6.5% to 1% as a result of the dot-com bubble burst and the 9/11 attack on the US World Trade Centre. As a result, people began to take home mortgage loans to buy homes, hence, increasing demand in the real estate market.
- Government policies encouraged home loans: An example of this was income tax-deductibility of the interest paid on home mortgages. This made home loans more attractive to consumers.
- The Great Moderation of the 1980s to 2007: This resulted in a period of low inflation, low interest rates and stable growth. Due to stability, more consumers became risky later on and were willing to become lenders.
Eventually, the bubble formed resulted in a decline in mortgage standards and the qualifications that one would need to qualify for a loan. In fact, financial institutions began to lend money to sub-prime borrowers. This is an important term as this crisis is sometimes known as the sub-prime mortgage crisis. Subprime borrowers are essentially those with little to no credit. Banks believed that if these borrowers could not repay their loans, they would sell their houses and take their money back. However, by 2007, prices started to decline. The market became saturated and the government began to raise interest rates.
Hence, people began to default (not pay) their home mortgage loans and their homes were not worth anything. This resulted in a large-spread foreclosure, that is where banks would have to sell off homes to recover their loans. However, since house prices were low, banks made losses on their foreclosures.
The biggest issue arose as the crisis began to spread all over the world due to inadequate regulations and the sheer complexities of financial instruments such as mortgage-backed securities that allowed international investors to invest in the US financial housing market. Eventually, through regulation and other systemic recovery measures, markets were back into place. However, much has been learned from this crisis and the world is said to be better off after it.