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Financial Crisis 07-08
Financial crises have occurred persistently throughout history, originating from the creation of the first empires and the formation of colonies. Their appearances can sometimes be unexpected. However, crises can be controlled and escalated to more threatening and severe situations like depressions through the implementation of rules and regulations. The global economic crisis of 07-08 arose primarily as a result of a significant reduction in financial regulations that were implemented during the Great Depression era with the intention of stabilizing the economy and preventing future economic disasters from recurring. Its origins can be traced in the United States to the low interest rate policies implemented by the government itself to encourage home ownership, and to the introduction of many risk-taking techniques such as derivatives, which were bets made on the solvency of a particular company. Other countries such as Iceland, Japan, Spain, United Kingdom and many more also adapted these tactics, which later resulted in unfavorable results for their economies.
In 1999, Congress passed the “Gramm-Leach-Bliley Act” which reversed the Glass-Steagall Act. The Glass-Steagall Act was approved in 1933 in order to prevent banks from engaging in risky activities such as speculation with depositors’ savings and affiliation with other companies. 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 stimulants that contributed to the erosion of confidence that profits will remain at low levels. As a result of deregulation, products such as derivatives were invented and quickly brought to market in what Warren Buffett refers to as weapons of mass destruction. Credit default swaps and secured debt obligations were the most common. This led to the development of the securitization process, where the party making the loan is not affected if there is a default on the part of the borrower. This was mainly because the lenders sold the mortgages to the investment banks. Investment banks then combined these mortgages with other loans such as auto loans, credit card loans, and student loans.
This resulted in the formation of collateralized debt obligations or CDOs, which were sold to investors around the world. Since all of these products have been rated triple A or the highest investment grade by rating agencies, many investors have perceived them as safe, risk-free investments. Lenders began to make riskier loans since they had no liability for them going bad. Investment banks, on the other hand, ignored the instability of loans 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 safe for investors on their purchased CDOs. Insurance companies such as AIG were the main service providers and promised to pay any losses to investors in case the CDOs went to bed.
Another important fact to note is that in the derivatives market other speculators can also buy insurance for a CDO that they do not own. This put insurance companies at greater risk after they became responsible for covering 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 deregulation of the derivatives market, insurance companies were not required to declare any amount of money set aside to cover losses should they occur. This exposed AIG and many other insurance companies to high levels of risk, which later resulted in catastrophe. In early 2007, the situation intensified and panic began to gain ground on a large scale. As credit strains became excruciating, economic activity began to deteriorate. Lenders’ caution and not to extend additional credit was followed by massive loan defaults and bankruptcy filings as many institutions around the world began to face liquidity problems and were unable to pay their obligations. A decline in GDP was quickly noticed in many countries, especially in Europe and East Asia. This was mainly due to the collapse of consumer confidence, low demand for goods and declining production worldwide. Unemployment skyrocketed as many companies tried to mitigate the threat of bankruptcy by laying off large numbers of their employees. The unemployment rate reached a historic high in some European countries where it exceeded 27%.
On the other hand, China, the world’s second largest economy, was mainly affected by a decline in world trade given its high role as an exporter. The 07-08 financial crisis is recognized as one of the most severe and painful financial crises to hit the world economy in the years following the Great Depression. Currently, many governments around the world have taken preventive measures for regulation and many new policies are implemented to stabilize the economy and prevent future crises. The United States of America, the epicenter of the 07-08 financial crisis, is now pursuing a more regulated approach with the intention of substantially mitigating the consequences it is currently facing.
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