2008:The Financial crisis Explained...

The 2008 financial crisis also known as Sub-Prime crisis, Global financial crisis was the worst ever crisis after the Great Depression of 1929. The impact of the crisis had affected the whole world. Many big companies like Lehman Brothers collapsed due to the crisis. 

In the year 2001 the interest rates went down to 1% and due to the implications of dot com bubble burst the share prices were continuously falling in the stock market, which discouraged the investors to park their funds in banks as well as to invest in stock market. At that time real estate sector was doing extremely well, and The U.S Govt. was also encouraging the people to buy houses and properties. As the interest rates were low, people started buying the houses by financing through loan from banks. Due to increasing demand of houses, the prices kept on rising and  thus attracting more investors to invest their funds. Investment banks were largely attracted seeing the opportunity to gain money. So they started buying loan from  banks and financial institutions by paying fees and combined them, making a complex derivative  product termed as Collateral Debt Obligations (CDOs). They got AAA - rating done by the rating agencies. Due to the good rating & returns investors were attracted towards CDOs. So the demand for loans increased and the banks ultimately started giving loans to everyone without any prior assessment and verification of the financial condition of borrower, and thus no guarantee of repayment. These loans are called Subprime Loans. The banks also paid the full amount of the house as loan, thus the borrower didn’t had to pay any amount from his own pocket.

The Subprime loans were sold by the commercial banks to the Investment banks and then these were converted to CDOs and sold to investors. The ultimate risk was transferred to the investors. The two major bank to provide subprime loans were Countrywide Financial. Corp and Amerequest Mortgage Company worth $177Bn (USD). This continued till 2008 where all the parties were gaining huge profits out of this business.

AIG an insurance company, that provided insurance on the CDOs named it Credit Default Swap (CDS). All the CDO investors who accessed the risk, started taking insurance for protection against the losses. The premium was paid to AIG in every three months. In case the insured incur any losses would be compensated by AIG.

So what went wrong from then ?

Most of the subprime loans by banks were adjustable interest loans and many borrowers had no idea about this fact. The adjustable interest loans are those loans whose interest rate changes as market rate fluctuates. First they had to pay lesser interest rates, which gradually kept on increasing. Thus the borrowers started defaulting in payments as the EMIs had gradually increased due to increase in the interest rates. When banks were finding difficulties in recovering the amount, they started selling the properties to recover the amount.

The no. of properties that were auctioned was huge, thus the banks were not able to find buyer for the properties, which resulted in huge decline in the value of properties. By seeing this, no one was willing to repay the loan for lesser value of properties. Due to these defaults the value of CDOs went down to 0, and the investors of CDOs incurred huge losses. As some of the CDOs were insured by AIG, it had to pass the claims, thus it incurred losses of $99bn (USD). AIG was a big company and the U.S Government bailed out AIG by putting $85bn (USD). 

The remaining CDOs with the investment banks were not able to attract investors further, and thus they incurred huge losses. The top 5 U.S Banks were intensively affected due to this. The Lehman Brothers one of the top investment banks of U.S gone bankrupt. Bear Stearns was acquired by J.P Morgan Chase, and Merrill Lynch was acquired by Bank Of America. The total loss estimated to banks and financial institutions was around $450bn (USD).

This resulted in credit crunch in the economy and business were finding it difficult to raise money and thus were forced to close. Unemployment rose to 10% in U.S. This recession has also impacted the global trades as U.S is the biggest economy and all the economies are interconnected through globalization. And this ultimately has resulted in Global Recession.