What is a Financial Crisis
In a financial crisis, asset prices see a steep decline in value, businesses and consumers are unable to pay their debts and financial institutions experience liquidity shortages. A financial crisis is often associated with a panic or a bank run where investors sell off assets or withdraw money from savings accounts because they fear that the value of those assets will drop if they remain in a financial institution.
What Causes a Financial Crisis
A financial crisis can occur if institutions or assets are overvalued, and it can be exacerbated by irrational investor behavior. A rapid string of selloffs can further result in lower asset prices or more savings withdrawals. If left unchecked, a crisis can cause an economy to go into a recession or depression.
The 2008-09 Financial Crisis
The 2008-09 financial crisis was the worst economic disaster since the Great Depression of 1929. The crisis was the result of a sequence of events, each with its own trigger and culminating in the 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 the Community Development Act, which forced banks to loosen their credit requirements for lower-income consumers 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, when the Federal Reserve Board began to cut interest rates drastically to avoid a recession. The combination of loose credit requirements and cheap money spurred a housing boom, which drove speculation pushing up housing prices and creating a real estate bubble.
In the meantime, the investment banks, looking for easy profits in the wake of the dotcom bust and 2001 recession, created collateralized debt obligations (CDOs) from the 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. When the market for CDOs began to heat up, the housing bubble that had been building up for several years 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 CDOs were worthless due to the toxic debt they represented, they attempted to unload the obligations. However, there was no market for the CDOs. The subsequent cascade of subprime lender failures created liquidity contagion that reached 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 and were rescued by a taxpayer-funded bailout.
The U.S. Government responded to the Financial Crisis by lowering interest rates to nearly zero, buying back mortgage and government debt, and bailing out some struggling financial institutions. The government response ignited the stock market, which went on a ten year bull run with the S&P 500 returning 250 percent over that time. The U.S. housing market recovered in most major cities, and the unemployment rate fell as businesses began to hire and make more investments.