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What is a 'Financial Crisis'

A financial crisis is a situation in which the value of financial institutions or assets drops rapidly. A financial crisis is often associated with a panic or a run on the banks, in which investors sell off assets or withdraw money from savings accounts with the expectation that the value of those assets will drop if they remain at a financial institution.

BREAKING DOWN 'Financial Crisis'

A financial crisis can occur as a result of institutions or assets being overvalued, and it can be exacerbated by investor behavior. A rapid string of selloffs can further result in lower asset prices or more savings withdrawals. If left unchecked, the crisis can cause the economy to go into a recession or depression.

How the 2008 Financial Crisis Happened

The 2008 financial crisis was the worst economic disaster since the Great Depression of 1929. The root cause has been traced to no one single event or reason. Rather, it was the result of a sequence of events, each with its own triggering mechanism that led to near collapse of the banking system. It has been argued that the seeds of the crisis were sown as far back as the 1970s with Community Development Act, which forced banks to loosen their credit requirements for lower-income minorities, creating a market for subprime mortgages.

The amount of subprime mortgage debt, which was guaranteed by Freddie Mac and Fannie Mae, continued to expand into the early 2000s, about the time the Federal Reserve Board began to cut interest rates drastically to fend off a recession. The combination of loose credit requirements and cheap money spurred a housing boom, which drove speculation, which drove up housing prices.

In the meantime, the investment banks, looking for easy profits in the wake of the dotcom bust and 2001 recession, created collateralized debt obligations (CBOs) out of mortgages purchased on the secondary market. Because subprime mortgages were bundled with prime mortgages, there was no way for investors to understand the risks associated with the product. Around the time when the market for CBOs was heating up, the housing bubble that had been building up for several years was beginning to burst. As housing prices fell, subprime borrowers began to default on loans that were worth more than their homes, accelerating the decline in prices.

When investors realized the CBOs were becoming worthless due to the toxic debt they represented, they tried to unload them, but there was no market for them. This caused a cascade of subprime lender failures, which created a liquidity contagion that worked its way to the upper tiers of the banking system. Two major investment banks, Lehman Brothers and Bear Stearns, collapsed under the weight of their exposure to the subprime debt, and more than 450 banks failed over the next five years. Several of the major banks were on the brink of failure had it not been for a taxpayer-funded bailout.

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