This paper examines the principal causes and consequences of the 2007–2009 global financial crisis. It traces the crisis from the U.S. housing bubble and the securitization of risky mortgage-backed assets, through the failure of credit rating agencies to accurately assess those products, to the worldwide spread of toxic securities into bank portfolios. The paper then follows the chain reaction triggered by rising interest rates and mass mortgage defaults — culminating in high-profile bank failures such as Lehman Brothers — and discusses how the resulting credit crunch, government bailouts, and fiscal austerity extended the downturn across the developed world. The paper concludes by noting the persistent low-interest-rate environment that continues to reflect the crisis's unresolved legacy.
There were a number of causes of the global financial crisis of 2007–2009. Baily, Litan, and Johnson (2008) argue that there were numerous contributing factors, including the perception of a low-risk U.S. housing market, the securitization of that market, the role of credit rating agencies, and the spread of these securities to financial institutions around the world. The primary contagion came from the United States, beginning in 2007, but contributing factors existed in many European countries as well.
The U.S. housing market entered a bubble state, with rapidly increasing prices. This was the result of changes to the way mortgages were financed, which brought more — and riskier — consumers into the housing market and in turn fueled speculators. Banks were able to securitize risk from the housing market, and through complex transactions they offloaded much of that risk onto other financial institutions around the world.
Credit rating agencies, lacking a clear understanding of these products, rated them as secure investments. These ostensibly "secure" investments offered returns much higher than other investments of similar apparent safety — but of course they were not as secure as their ratings suggested. Nevertheless, they had become popular investment items for banks around the world precisely because of their perceived safety. Baily et al. (2008) noted that risk management was poor. In countries where banks exercised proper risk management — Australia and Canada most notably — the economic crisis was nowhere near as severe.
Tridico (2012) explains what happened next. With uneven income distribution, the expansion of consumer credit represented by the new U.S. mortgage market was unsustainable, and it inevitably began to collapse shortly after the U.S. Federal Reserve raised interest rates — most mortgages had been issued on floating terms with low introductory rates. This resulted in a dramatic increase in mortgage defaults, threatening the supposedly secure mortgage-backed securities that had spread throughout the global financial system.
Banks heavily invested in these securities, such as Lehman Brothers, went bankrupt, causing a mass crisis of confidence in the entire financial system. That crisis of confidence extended to all countries where banks held these assets (The Economist, 2013). This is what made the crisis global in nature rather than merely an American problem — banks all over the world had been buying these securities.
"Lehman Brothers collapse and global credit freeze"
"Bailouts, budget crises, and weak policy action"
"Persistent low interest rates and suppressed growth"
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