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What are the reasons for global financial crisis?

Updated: 8/17/2019
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15y ago

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The financial crisis started a couple years ago around 2001 (before 9/11). The economy was starting to go into a recession (and it did) from the dot com bust along with the Enron scandal. There were a couple of events also happened adversely effecting the economy. The Glass Steagall Act overturned a Depression era regulation that maintained the separation of commercial banking and financial banking. Also during this almost recession was Alan Greenspan then chairman of the Fed lowered the United States interest rates to try and further avoid a decline in the economy. This was happening along a growing savings bundle in the Middle East, Southeast Asia, India, and China as their economies were growing very rapidly and wanted somewhere to invest these savings to gain a return on them. The Glass Steagall Act created the means to allow banks for the potential for unlimited profits, using regular savings as a means to invest into Wall Street which is much riskier. With this huge pool of money, investors from around the world wanted a low risk investment with relatively (relative to the risk) good returns, but the interest rates in the United States limited these opportunities because the United States is such a stable place of investment. In order to satisfy this tremendous savings demand financial analysts created, manipulated numbers, formulas, derivatives to create a type of bond/investment based on mortgages, and the booming housing market in the United States and in other places around the world. These instruments would be called mortgage backed securities. Good mortgages (people with mortgages that have good credit) and bad mortgages were then bundled together The process and math behind these manipulations of these mortgages are so complicated that many of the hedge fund brokers did not even know what was going on with them except that they were making gangbusters on them, so they ignored the logic behind why they are getting so much money and instead focused on creating as many mortgages as they could in order to make as much profit as possible. These investments were seen by the credit rating bureaus and the financial institutions as very stable and very profitable for their risk. Many The problem is the proliferation and popularity of these funds were based on the fact that housing prices were sustainable; they were going to be high for a very long time and that the good returns off these instruments would continue as long as house prices remained high or grew and people would not foreclose on their mortgage.

Big problems with these assumptions were that in order to create so many mortgages they had to dig into the subprime mortgage market. Traditionally mortgages were very exclusive you had to have very good credit and you had to put down a pretty large down payment to buy property or houses. These traditional practices were bypassed in order to take advantage of the huge potential profits people in the financial sector and so the subprime mortgage market was tapped, where mortgages were given on terms that were never even heard of before, where mortgages were given without anything but a signature. There was no credit check, there was no down payment, and where the traditional long process of thinking about and understanding the terms of the loan were bypassed because there seemed to be no risk on the part of the lender so there was no need for the lender to educate the borrower on the terms of the agreement (these terms would become very important later) Role of predatory lending- Mortgage lenders would get people to get mortgages and these mortgage lenders would sell these rights to the loans to banks. The banks would then sell these rights to investors which would leave them with even more money to buy more mortgage rights and the process would continue (hopefully in their mind for forever). Trying to buy more things with money you borrow and then sell them for a profit is called leveraging your assets. Unfortunately these trends did not last and the housing prices bubble did burst and the prices of these houses plummeted. The number of failed mortgages blew up and the securitization of mortgages were useless as the diversification became useless because too many of the mortgages failed so the good mortgages could not make up for the bad ones. This is why the banks are failing now or becoming insolvent, unable to pay back their customers as they invested huge sums of money (their capital) into the now failed mortgage market. With the news reporting that the banks' mortgages are not being repaid people with money in the banks they started trying to get their money back, but they didn't have enough left in the reserve so they needed the government to step in or else the banks would collapse. The biggest factor in the popularity of these derivative based instruments was a tool called credit default swaps. These tools basically gave a perceived notion that the risk associated with the mortgage market by allowing AIG (mainly) to insure the mortgages. These perceptions of the mortgage and insurance market were largely false and gave the notion that all these firms could keep creating mortgages without any risk. Unfortunately AIG had no capital to back all the insurance claims and the housing market collapsed. AIG's role in "insuring" these securities is a huge reason why the world is in the crisis we are in today.

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