Explaining the Financial Crisis | Causes and Effects

By :  ,  Financial Writer

What is a financial crisis?

A financial crisis is a severe economic meltdown that occurs when the markets within an asset class, such as stocks or real estate, rapidly lose value. This steep devaluation sets off a chain reaction of bank runs and debt defaults, meaning both individuals and financial institutions are unable to pay debts or lend money. Financial gridlocks occur as a result, and as a result, no entity can pay or lend money to any other entity.

Examples of financial crises include stock market crashes, credit crunches, sovereign defaults, currency crises and bubble bursts. In the case of global financial crises, issues begin in one country or region before rippling throughout the rest of the world. According to the financial historian Charles Kindleberger, financial crises occur on average once every 10 years.

Financial crises have existed for centuries, from the Tulip Mania in 1600s Holland to the most recent worldwide financial crisis caused by the spread of COVID-19. Later in this article, we’ll examine one of the most severe examples: the 2008 financial crisis.

What causes a financial crisis?

A financial crisis often has multiple causes. Usually, one issue triggers more in a domino effect. Three main causes you’ll spot in almost every financial crisis are an overvaluation of assets, regulatory failures, and bank runs.

Let’s take a closer look at each.

Overvalued assets

Assets, such as stocks, become overvalued often due to investor misjudgement. This misjudgement occurs when a stock’s price rises far above its intrinsic value, often determined by the company’s earnings outlook or price-earnings (P/E) ratio. Often more passive or inexperienced investors notice when a stock’s value is abnormally rising and jump to mimic it, afraid of missing the opportunity and potential profits. This overvaluation leads to a crisis when investors recognize the overvaluation and sell off their shares, often in mass, causing the price to drop.

This action can occur in other markets as well, such as real estate in the 2008 global financial crisis or the extreme volatility seen in crypto markets. Overvaluation does not always lead to a financial crisis, but a financial crisis almost always includes overvalued assets.

Overvalued assets are more likely to trigger a financial crisis when the investments in that asset are borrowed on debt or overleveraged, meaning that investors who do not get out in time are unable to fulfil their oversized losses.

Regulation failures

Financial regulations are any form of supervision put in place to ensure financial systems run as expected. These regulations serve many purposes in an economy such as ensuring financial transactions are conducted legally, promoting fair competition in the marketplace, protecting consumers from predatory behaviour, and stability is maintained in financial systems at large.

When regulatory failures occur, overvalued assets can cause much more damage than if the problem was limited to that one instrument. As you’ll read in our 2008 financial crisis case study, the regulatory mishandling of overleveraged sub-prime mortgages helped propel the housing crisis to blow up other sectors of the financial industry.

A gap in proper regulation can be seen as a potential to outsize profits by hungry investors, but their exploitation harms the entire system.

Bank runs

A bank run is when depositors, afraid the bank or other financial institution will become insolvent, withdraw their funds in large numbers. If enough people withdraw their funds, banks become insolvent, making bank runs a self-fulfilling prophecy.

The 2008 financial crisis: a case study

The housing market crash of 2008 sparked a global financial crisis the size of which had not occurred since the Wall Street Crash of 1929. Trillions of dollars were lost in global markets as a result of the crisis, and it took nearly a decade to lower unemployment back to pre-2008 levels. Read on to find out how the 2008 financial crisis started and just how much money was lost.

How did the 2008 financial crisis start?

The 2008 financial crisis began in the early 2000s when investors looking for new, safe sources of return turned to mortgages, a loan typically granted to an individual for the purchase of a house or other real estate.

Predatory lending and overleveraging of financial institutions to capitalize on this new investment class would eventually bring about the real estate crash that caused the 2008 financial crisis. Keep reading to understand how such a promising market broke down.

What caused the 2008 financial crisis?

The 2008 financial crisis was caused by the collapse of the US housing market. That collapse was brought about by many factors, but the primary ones included an overvalued housing market, regulatory oversights allowing investors to overleverage mortgages, and widespread insolvency on the predatory subprime mortgages.

Immoderate investments and deregulation

After two decades of moderate and stable economic growth in the US, investors gained more confidence towards risky financial behaviour such as taking excess debt to leverage aggressive investments. These same beliefs allowed successive deregulations that opened the door for banks and brokerages to grow so large they were believed to be “too big to fail.”

Loose lending standards in the housing market

US real estate values had been rising steadily for decades by the 21st century, encouraging more people to buy property. Mortgage lenders began approving as many loans as possible regardless of the borrowers’ credit scores or approval ratings, using a new class of mortgages called subprime mortgages characterized by low standards and high-interest rates.

Increased risk-taking by professional investors

With regulations and standards now out of the way, these “infallible” investment banks continued to leverage subprime mortgages, bundling them with other loan types to create new securities they could then sell more shares of to individual investors.

In an example of regulatory failure, credit rating agencies claimed these new securities were safe and sound investments, even though subprime mortgages were known to be high-risk, encouraging investors to take on more debt to extend their investments in these profitable and seemingly safe securities.

Insurance institutions even got in on the boom, selling derivatives that would pay out investors if subprime mortgages were defaulted on. However, the widespread defaults soon to come would be too much for them to handle.

Subprime mortgage crisis

Housing prices and interest rates kept rising until homebuyers were unable to make mortgage payments, especially on predatory subprime mortgages with interest rates that jumped even higher after the first year.

In April 2007 as more people began defaulting on subprime mortgages, New Century Financial, the largest independent provider of subprime mortgages, declared bankruptcy. These mass defaults dragged down the securities the subprime mortgages were wrapped up in, meaning the effects were felt beyond the housing market and hedge fund managers and investment banks were forced to write off a substantial amount of their value.

What happened in the 2008 financial crisis?

By the spring of 2008, one of the largest investment banks, Lehman Brothers, owed $600 billion in debt. When Lehman declared bankruptcy in September 2008, banks stopped lending completely and the entire global system became illiquid.

Within weeks, the Dow Jones Industrial Index lost 3600 points, Merrill Lynch was bought by Bank of America, the FDIC seized and transferred Washington Mutual’s assets to JPMorgan Chase, and Goldman Sachs and Morgan Stanley converted from investment banks to bank holding companies to obtain more federal bailouts. International trade and industrial production fell faster than they did during the Great Depression while mass layoffs and record unemployment levels occurred around the world.

How much money was lost in the 2008 financial crisis?

The money lost in the 2008 financial crisis totals trillions of dollars. It’s difficult to calculate the total cost of the crisis because of its widespread and long-lasting effects. However, in April 2012 the Treasury Department published an estimation of money lost.

The total household wealth lost in the US was $19.2 trillion from forfeiting real estate after defaulting on mortgages along with income lost due to mass layoffs that occurred after the crash when unemployment jumped from 5% to 10% by October 2009.

The US government then poured an estimated $23 trillion into bailouts and other programs, mainly for the financial institutions that caused the crash.

Losses in the stock market also erased $6.9 trillion in shareholder wealth that year, with the Dow Jones losing half of its value from its 2007 peak and not regaining those losses until March 2013.

Is another financial crisis coming?

As Kindleberger noted, a financial crisis should be expected every 10 years or so. The global recession in 2019 caused by COVID-19 seems to support that assertion.

Whatever financial crisis comes next likely won’t be as bad as the one in 2008, but it is safe practise to hedge your investments and be prepared for any crisis that may occur.

What is the best investment during a financial crisis?

The best investments during a financial crisis are well-managed companies with low debt and strong balance sheets. Industries like utilities, consumer staples, and discount retailers are considered defensive stocks.

Federal and municipal bonds are also good choices to house your money in during times of high financial risk. Investing in the government eliminates credit risk because of the government’s ability to levy taxes and print money. Although it’s important to remember that these safer investment options have lower returns as well. 

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