Financial crises have occurred persistently throughout history since the creation of the first empires and the formation of colonies. His appearances can sometimes be unexpected. However, crises can be controlled from escalating into more threatening and serious situations, such as depressions, by implementing rules and regulations. The global economic crisis of 07-08 arose primarily as a result of a significant reduction in financial regulations that were put in place during the Great Depression era with the intent of stabilizing the economy and preventing a repeat of future economic disasters. Its origins can be traced in the United States to government-imposed low interest rate policies to encourage home ownership and the introduction of many risk-taking techniques such as derivatives, which were bets on the creditworthiness of a specific company. Other countries like Iceland, Japan, Spain, the UK, and many more also adapted these tactics, which later resulted in unfavorable outcomes for their economies.
In 1999, Congress passed the “Gramm-Leach-Bliley Act” which struck down the Glass-Steagall Act. The Glass-Steagall Act was passed in 1933 to prevent banks from engaging in risky activities, such as speculating on depositors’ savings and affiliates with other businesses. This change in regulations allowed many investment banks to operate profusely as they began to enter a new era of global financial liberalization. Greed and dissatisfaction were the first stimulators that contributed to the erosion of confidence that earnings will remain low. As a result of deregulation, products like the derivatives that Warren Buffett refers to as weapons of mass destruction were invented and quickly brought to market. Credit default swaps and collateralized debt obligations were the most common. This led to the development of the securitization process, where the lending party is not affected if the borrower defaults. This was mainly because the lenders sold the mortgages to the investment banks. Investment banks then bundled these mortgages with other loans, such as auto loans, credit card loans, and student loans.
This led to the formation of the collateralized debt obligation, or CDO, which was sold to investors around the world. Since all of these products were rated triple A or the highest investment grade by rating agencies, they were perceived by many investors as safe and risk-free investments. Lenders began making riskier loans since they had no liability in terms of going bankrupt. Investment banks, on the other hand, ignored lending volatility as their main focus was to maximize their profits by selling more CDOs, which ultimately contributed to a further increase in predatory lending. Credit default swaps were another form of derivatives. They were insurance for investors regarding their purchased CDOs. Insurance companies like AIG were the main service providers, promising to pay any losses to investors in the event the CDOs failed.
Another important fact to keep in mind is that in the derivatives market, other speculators can also buy insurance for a CDO that does not belong to them. This put insurance companies at greater risk after they became liable to cover the losses of more than one party. Many investment banks began to bet against their CDOs indicating that they were going to go bad. As a result of the lack of regulation of the derivatives market, insurance companies were not required to disclose the amounts of money that had been set aside to cover losses in case they occurred. This exposed AIG and many other insurance companies to high levels of risk, which later resulted in a catastrophe. At the beginning of 2007, the situation escalated and the panic began to gain ground on a large scale. As credit stresses became dire, economic activity began to deteriorate. Lenders’ caution in extending additional credit was followed by massive loan defaults and bankruptcy filings, as many institutions around the world began to face liquidity problems and became unable to pay their obligations. A decline in GDP was quickly noted in many countries, especially in Europe and East Asia. This was mainly due to the collapse in consumer confidence, low demand for goods, and declining production around the world. Unemployment skyrocketed as many companies tried to mitigate the threat of bankruptcy by laying off large numbers of their employees. The unemployment rate reached an all-time high in certain European countries where it surpassed the 27% mark.
On the other hand, China, the second largest economy in the world, was mainly affected by a drop in world trade considering its high export role. The financial crisis of 07-08 is recognized as one of the most severe and painful financial crises to hit the world economy in the years since the Great Depression. At present, many governments around the world have taken precautionary measures towards regulation and many new policies are implemented to stabilize the economy and prevent future crises. The United States of America, the epicenter of the 2007-2008 financial crisis, is now pursuing a more regulated approach with the intention of substantially ameliorating the consequences it currently faces.