Updated: Mar 26, 2021
The financial crisis of 2008 caused havoc across global stock markets. It was a crisis triggered by the housing bubble in America. Millions of people lost their houses, even more lost their jobs!
So what actually happened? And why did it happen?
The crisis began with irresponsible mortgage lending in America. Loans were given to ‘sub prime’ borrowers who had no or little credibility. As borrowers were getting houses and lenders were getting payments, all was going good. However things changed soon. The mortgage lenders frequently sold these mortgages to banks to get more money for lending. The investment banks that were buying these securities would pool in different mortgages and sell them further to investors also called collateralised debt obligations (CDOs) .Theoretically this should have reduced risk and made these assets safe but in reality these mortgages were of poor quality or were ‘sub prime’.
Despite this these securities were rated AAA (top most ranking) as they were backed by credit default swaps . The US and the global banks went on a massive spending spree, borrowing large amounts of money at low rates to fund their investments in these assets.
However soon enough the sub prime borrowers defaulted on their mortgages and prices for houses went downwards. Prices became so low that the payment rates became higher than the actual house cost, discouraging more people from making payments anymore.
It was during 2007-08 that the default rates spiked. Investors started losing confidence in the AAA rated assets, their value fell. As value of the assets fell, market for them evaporated and banks that heavily invested in them experienced a liquidity crisis.
The first worrisome sign was the New Century Financial (subprime specialist lender) filing in for bankruptcy. In Mar 2008, JP Morgan had to buy Bear Stearns which was on the brink of a collapse.
Credit default swaps were unable to take the burden of so many defaults and banks started panicking as they realized that they’ll have to bear the losses on their own. The whole banking world was in a frenzy.
This led to Lehman Brothers to file in for bankruptcy. Other banks like Merrill Lynch, AIG etc were expected to follow. Their collapse was avoided by national governments like the US federal by incurring huge financial obligations. The US government signed an act to bailout it’s financial system. Even so, stock markets dropped worldwide and it was not before a few years that stabilisation and growth came back to the stock market world.