The 2007-2009 global financial crisis was an unprecedented economic disaster which affected many countries simultaneously and led to a global recession lasting for years. The crisis was triggered by the proliferation of high risk-financial products connected to subprime mortgages in the context of a deregulated environment. The Great Recession put at risk the need for financial globalization which amplified the risks of banking activities across the world and led to financial imbalances among countries. The impacts of the financial crisis were far-reaching, nearly collapsing the global financial system, driving markets down, and leading to multiple macroeconomic aftereffects in a recession such as high unemployment. The research poses the question of application of rules in global financial activity in order to mitigate risks that are inherent to globalization and financial activity of this level to prevent further crises.
Impact of the 2007-2009 Global Financial Recession
The 2007-2009 global financial recession also known as the Great Recession was the single greatest economic crises in the world economy prior to COVID-19 and after the Great Depression of the 1930s. Caused by multi-modal complexities in the financial system, government deregulation, and predatory lending practices, the crisis which was sparked by the housing market crash in the United States, quickly spread throughout the world. This collapse became a crisis for the globalization of the world economy. The impact of the 2007-2009 Global Financial Recession could be seen in international financial and banking systems, global commercial and trade markets, and socio-economic detriments as various financial and government systems and fail safes collapsed in this unprecedented recession.
Background and Causes
The events and causes leading up to the Great Recession are inherently complex and multi-causal. The primary events and factors associated with the crisis occurred in the U.S., although banking systems around the world were involved, and consequences of the global financial system being virtually broken could be felt by everyone. Deregulation of the financial industry is believed to be the core cause of the crisis. The 1999 Gramm-Leach-Bliley Act in the U.S. began the process by allowing banks to invest in derivatives. Derivates consisted of mortgage-backed securities and collateralized debt obligations, which were financial products based on the value of the mortgage to be used from collateral. Banks sold mortgages to hedge funds, which in turn bundled them together based on computerized models and sold them to investors. As households paid their mortgages to the bank, the sum was sent along down the line, with each party getting a percentage of the profit. It was virtually risk-free since mortgages have historically been considered one of the safest and least defaulted upon assets. By 2004, the U.S. SEC relaxed a rule which allowed for investment banks to take on significantly more debt (Amadeo, 2021).
The system essentially created a pyramid scheme in a way. While all risk was the final investors purchasing the bundles, they purchased insurance known as credit default swaps offered by major insurance companies. The popularity of mortgage-backed securities was so widespread that everyone was involved including large international banks, hedge funds, pension funds, insurance, and individual investors. However, at some point the mortgages began to run out. This led to a shift in lending standards, which were already ongoing but fueled by this demand for mortgage-backed securities. Due to favorable economic conditions, loans were more readily given out to families who could not previously afford a mortgage. As time went on, the quality of these loans decreased, and they became known as subprime mortgages, essentially high-risk loans. Banks used weak or highly fraudulent underwriting practices, collapsing the standards. Many institutions practiced predatory lending to entice consumers that would not generally meet appropriate standards for a mortgage. A significant portion of the mortgages were sold on adjustable rates, which had low percentage rates in good economic times, but could rapidly climb if conditions worsened. However, these subprime mortgages were still sold in bundles, with virtually no change in credit risk. It created what became known as the “housing bubble” (Gertler & Gilchirst, 2018)
By 2006, the U.S. Federal Reserve began to raise interest rates to manage inflation while housebuilding caught up with the demand resulting in house prices to go down steeply. As a result, the flow of credit into real estate slowed, and many of the adjustable mortgages reset at rates that the borrowers were led to expect. Therefore, even though families wanted to pay their mortgages, because they were subprime and adjustable, the rates at such high levels, that they could not make the payments. The issue is that they could not sell the house either based on the conditions, having to foreclose. This led to the collapse of the real estate market in 2007. At this point, the credit market which had financed the housing bubble, also descended into crisis. Over-leveraged banks and financial institutions lost solvency, and many collapsed, were taken over by the government, or bailed out. The most well-known were the collapse of the Bear Stearns and the Lehman Brothers in 2008, both extremely large investment banks. Everyone involved in the scheme listed earlier saw major losses, virtually bringing the U.S. financial system to its knees which rebounded across the global financial system and started the Great Recession (Weinberg, 2013).
Global Financial System
Although the U.S. housing market was the epicenter of the financial crisis, once the events unfolded and went downhill, it became evident that other countries in the world had either housing bubbles or banks having high-risk credit practices. Furthermore, many of the world’s largest banks based in Europe also had branches or involvement in the American market, so when the crisis hit, their solvency was under question as well. While the global economy dipped into recession affecting most everyone, this crisis was unique in that it affected largely advanced industrial societies rather than developing nations (Lund et al., 2018).
The world had for several years been undergoing the globalization of financial markets, institutes, instruments, and regulations, also known as financialization. The collapse of the global system through financialization made sense. In its basic form, financial investors are continuously seeking instruments and locations which can provide a stable and safe source of income. Securitization of assets was the vital financial innovation which led to the integration of global finance. At first, it was mortgage-backed securities, but once all collapsed and investment opportunities declined, money flow was directed out of advanced economies into prospective developing countries with financial instruments that could provide better returns than government bonds (Boyle, 2020).
The Great Recession represented the failure of multiple systems across the overstretched and overinvested global financial system, as each began to fall like dominos. Banks around the world including Northern Rock of England, UBS of Switzerland, and others experienced liquidity issues, having to apply for emergency funding from their respective central banks. As asset prices fell around the world, central banks attempted to coordinate billions of dollars in aid to international credit markets which were failing. As the world went into recession, the stock market collapsed rapidly. The only means to stabilize the economy was for governments to nationalize several banks while bailing out others and investing heavily into certain industries (Huart & Verdier, 2013).
The 2007 financial crisis was an example where financial innovation in the form of derivatives got ahead of regulation and then got taken advantage of by predatory lenders. The global financial industry has learned lessons. Notably, to surprise, the global system is less interconnected than it was, with money crossing border half of what it was in 2007. This is due to banks choosing to prefer doing business domestically rather than in foreign assets. There is much greater regulation for the industry now, beginning with the Dodd-Frank Act of 2009 in the U.S. which significantly limits such high-risk activities. Major banks in developed countries have risen their Tier 1 capital ratio from 4% to 15% in modern-day, indicating that institutions must hold significant capital to support their liquidity in cases where balance sheets may face sudden losses (London & Lund, 2018). While a lot of financial imbalances and highly volatile contexts have subsided and been corrected since the financial crisis, there are still a number of concerning issues such as overwhelming government and household debt that can cause issues down the line.
Global Markets
Alongside financial institutions, global markets, trade, and socioeconomic parameters were greatly affected as well. As the stock market fell due to lack of financing from the banking sector, companies found themselves losing value massively without much opportunity to attract new investors. As the economy plummeted into recession, companies began to make major cuts or declare bankruptcy due to overwhelming debt levels. As a result, unemployment reached a peak 10.6% (Huart & Verdier, 2013). Households defaulted on mortgages either due to adjustable rates or being let go from jobs, leading to an eviction crisis, particularly in the U.S. Even those who kept their homes, a combination of factors led to decline of household wealth, and in turn consumer consumption. Slowed consumption and lacking funding eventually led to slowing manufacturing and international trade decline. Certain industries felt the impact stronger than others, with many of the automotive industry giants for example, facing insolvency.
It is critical to discuss the socio-economic impacts of the financial crisis as well. The extent of these aftermaths varied around the world, with the U.S. carrying the brunt of the consequences while other countries with more social protections had governments intervene and spend billions on supporting their populations through austerity measures. The housing and eviction crisis was devastating to millions of families and households, unable to pay their mortgages and rent. The U.S. and Europe saw a rapid jump in homelessness and unemployment levels. There were subsequently a number of social consequences, some of which persist to this day including poverty, crime levels, decreased education and birth levels, increase of mental health issues and suicides, greater mistrust of the government and large institutions, among others. It had taken nearly a decade for the economy to return to pre-recession levels in some respects. As a result, households carry significantly more debt now with much less wealth, affecting lower-income populations the most (Glei et al., 2019).
Conclusions
As mentioned earlier, due to the means of how the global financial system was intertwined, securities linked in one way or another to the subprime mortgages were accumulated in financial markets and banks all over the world. Banks had no confidence in financial instruments in the market and stopped transactions leading a widespread financial paralysis. Many critics present the Great Recession as evidence of criticism of both the international financial system and globalization. In the latter 20th century, financial markets became the primary means for companies to finances activities. Governments took on a laissez-faire approach and regulation was applied to international and national financial markets. Banks became globalized, especially after a series of consolidations in the 1990s (Huart & Verdier, 2013). Due to decompartmentalization, banks became major financial players, financing both corporate and individual activities on the financial market. On one hand, financial globalization of opening national borders to capital flow led to decades of economic growth and helped to contain inflation prior to the crisis. At the same time, the unprecedented interconnectedness of global financial systems at the time simply led to the rapid spread of toxic products and subsequent collapse of the system (London & Lund, 2018). Furthermore, the banks themselves created the crisis through predatory practices and imbalances in capital flows between countries creating unsustainable bubbles, undermining stability and highlighting the ineffectiveness of self-regulation.
Recommendations
The free movement of capital across borders does not indicate a lack of rules. International cooperation within the G20 framework seeks to manage banking and financial systems to this day. The obvious stresses of globalization are seen everywhere, only further highlighted by the COVID-19 pandemic. The globalization of financial systems can bring various benefits but only remains effective if it is balanced and inclusive equally of all participants. As demonstrated by recent crises, it is unbalanced, tapping into global capital markets without recognizing that it is a two-way process, all economic actors must follow the same rules. With true international coordination on the global finacnial system, it will become healthier, more flexible, and adaptable to prevent such crises from occurring.
References
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Huwart, J., & Verdier, L. (2013). The 2008 financial crisis – A crisis of globalisation? In Economic globalization: Origins and Consequences (pp. 127-143). OECD Publishing. Web.
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Lund, S., Mehta, A., Manyika, J., & Goldshtein, D. (2018). A decade after the global financial crisis: What has (and hasn’t) changed? McKinsey & Company. Web.
Weinberg, J. (2013). The Great Recession and its aftermath. Federal Reserve History. Web.