This paper examines the Global Financial Crisis (GFC), widely regarded as the worst financial crisis since the Great Depression of the 1930s. Beginning in the U.S. subprime mortgage market, the crisis spread through derivative instruments, shadow banking, and securitization to destabilize financial institutions worldwide. The paper traces the crisis from its roots in low interest rates and predatory lending practices through the collapse of major institutions such as Lehman Brothers and Bear Stearns, and discusses the broader economic consequences for developed and developing economies alike. It also considers the role of excessive borrowing, credit default swaps, and inadequate regulatory oversight in amplifying the crisis into a global catastrophe.
The Global Financial Crisis (GFC) has been considered by financial experts and economists as the worst financial crisis since the Great Depression of the 1930s. The GFC led to the collapse of large financial institutions and downturns in major stock markets globally. The crisis caused the failure of several key businesses and a significant decline in economic activity. The GFC originated in the U.S. mortgage markets, leading to significant turbulence and uncertainty in global capital markets (Kalinowski 2011). The source of the financial crisis was excessive risk-taking driven by sustained low interest rates, which encouraged investors to maximize their profits.
The root causes of the GFC began in 2001, when many U.S. financial institutions increased the number of mortgage loans they issued due to low interest rates. This led to a rise in the prices of residential real estate. During that period, there was a dramatic increase in the number of lenders granting loans to people with poor credit histories. However, between 2006 and 2007, a reversal occurred: rising interest rates led to a decline in residential property prices in the United States. Many high-risk borrowers were unable to meet their financial obligations, and the crisis that started in the subprime loan market was transferred into a global liquidity crisis.
Unlike past financial crises — such as the 1999 Brazilian crisis, the 1997 Asian crisis, and the 1998 Russian financial crisis — the GFC was the most far-reaching of all modern financial crises because it triggered prolonged worldwide fear and significant spillover and correlation among international financial markets in both developed and emerging economies (Cheung, Fung, and Tsai 2010).
The major cause of the GFC is attributed to the subprime mortgage sector and the collapse of the housing market in the United States. Between 1997 and 2006, the prices of American housing increased by 124%, and declining interest rates fueled the growth of subprime lending. In the United States, intense competition among mortgage lenders led them to provide loans to people with poor credit histories. Subprime lending had remained below 10% before 2004; however, between 2005 and 2006, it increased to nearly 20%. Subprime lending refers to the practice of financial institutions granting loans to borrowers with weak or bad credit histories. By 2007, the U.S. subprime mortgage market was estimated at $1.3 trillion.
Throughout the 2000s, there was significant growth in predatory mortgage lending — the practice of unscrupulous lenders enticing customers to apply for unsafe loan products. A classic technique used to draw people into insecure loan agreements was advertising low introductory interest rates of between 1% and 1.5% for mortgages. Once borrowers entered into these agreements, they were placed into adjustable-rate mortgages (ARMs) that required them to pay considerably higher interest rates than those initially advertised. This practice of information asymmetry inflated housing prices by drawing many buyers into the market under false pretenses.
However, between 2006 and 2007, growing concerns about inflation led to rising commodity prices in the United States. The U.S. government responded by tightening monetary policy. When interest rates declined again in 2008, average U.S. housing prices had already fallen by approximately 20%. With the gradual decline in housing prices, many borrowers with adjustable-rate mortgages were unable to refinance. Defaults rose sharply, and by 2007, lenders had initiated foreclosure proceedings on nearly 1.3 million properties. The collapse in subprime lending then spread, creating a financial crisis for major mortgage firms such as AIG, Bear Stearns, and Lehman Brothers.
The crisis damaged investor confidence through its severe impact on global stock markets. Between 2008 and 2009, the decline in the U.S. economy contributed to a broader global economic downturn, and the U.S. government responded to these financial shocks by implementing a bank bailout policy (Merrouche and Nier 2010). Iqbal (2010) argues that the financial crisis led to a decline in the standard of living for billions of people worldwide, pushing many in developing countries back into poverty. Europe also experienced its worst economic slump as a result of the GFC. Crotty (2009) argues that globalization had made the banking system inherently interdependent, so when the crisis began to unfold in the U.S., institutions abroad — such as BNP Paribas, one of France's largest banks — immediately announced shortages of liquidity.
Kalinowski (2011) argues that derivatives were a major cause of the financial crisis. The use of derivative instruments such as swaps and credit ratings by financial institutions contributed to speculative bubbles in U.S. financial markets. Many financial institutions took excessive risks, leading to uncertainty and liquidity constraints. Some banks were forced to write off portions of their balance sheets due to declining credit availability.
The derivative market is one of the largest in the U.S. financial system, yet it remained largely unregulated with respect to information disclosure between the parties involved. Since banks and other financial institutions participated in derivatives markets through hedge funds, transactions could occur in private without public visibility. The lack of oversight allowed increasingly risky transactions to go unmonitored. While companies legitimately used derivatives to manage financial risks — such as currency fluctuations, interest rate changes, and shifts in fuel and commodity prices — banks also sought additional earnings through speculative derivative transactions. These speculative activities caused significant losses at many financial institutions and contributed to the progressive drying up of liquidity. This is why Warren Buffett famously labeled derivatives and credit default swaps as "financial weapons of mass destruction."
Mishkin (2011) reveals that many banks were unable to convert their long-term assets into cash as a result of their derivatives exposure. Derivatives led many banks to take risky ventures through the shadow banking system, allowing borrowers to post collateral of only 5%. For example, when a borrower took out a loan worth $100 million, banks permitted the borrower to post collateral worth $105 million in mortgage-backed securities. In 2007, the value of mortgage-backed securities fell sharply, causing widespread losses. The same amount of collateral could no longer support the same level of borrowing, and to cover their losses, many financial institutions were forced to sell off assets.
Securitization also played a central role in amplifying the crisis. As Douglas (2009, p. 2) explains:
"Securitization allows originators (such as banks) of assets (such as residential mortgages) to transform a future stream of revenue (i.e., loan repayments) into a present value pool of capital, which can then be used to support further lending. In order to be effective, this process requires investors willing to purchase the resulting securities."
While securitization theoretically makes sense as a mechanism for redistributing risk across a wide range of investors, over time it evolved into increasingly complex financial techniques, including collateralized debt obligations (CDOs), structured investment vehicles (SIVs), and collateralized loan obligations (CLOs). Many of these transactions occurred through over-the-counter (OTC) derivatives, particularly credit default swaps (CDSs). A CDS is a bilateral derivative transaction that serves as protection in the event of default. By 2007, however, derivative transactions had reached unsustainable levels. As countries around the world raised interest rates to address inflationary pressures, growing numbers of U.S. borrowers found themselves unable to meet their loan obligations, triggering a cascade of defaults and a sharp decline in housing prices. These events had a negative impact on virtually all asset classes globally, with the exception of U.S., German, and Japanese government bonds.
Douglas (2009) also argues that the global crisis was attributable to excessive domestic and international borrowing across commercial real estate, commodities, corporate lending, and international equity markets — a problem that was not limited to the United States but was a truly global phenomenon. Excessive borrowing was closely interconnected with securitization, creating a self-reinforcing cycle of leverage and risk-taking that ultimately proved unsustainable.
The bankruptcy and collapse of Lehman Brothers in 2008 represents the defining moment of the GFC and the primary source of subsequent financial and economic disruption in the United States. Evidence shows that Lehman Brothers — then the fourth-largest bank in the United States — was deeply involved in the shadow banking system. The bank had recorded heavy losses in the subprime market, ultimately leading it to file for bankruptcy in 2008.
The bankruptcy of Lehman Brothers triggered a wave of panic among investors, causing a rapid drying up of liquidity and a collapse in asset prices. Lehman Brothers had taken excessive risks by capitalizing on moral hazard and shadow accounting practices to conceal its true leverage. It was among the most highly leveraged investment banks, with poor risk management practices. The bank held large positions in subprime mortgage-backed securities whose valuations had become deeply impaired. Lehman Brothers also participated in derivatives contracts that were unwound following its bankruptcy filing, further destabilizing counterparties across global financial markets.
The events surrounding Bear Stearns followed a similar pattern. Bear Stearns, the fifth-largest investment bank in the United States, had direct involvement in U.S. capital markets and faced severe liquidity problems in 2008. The Federal Reserve Bank provided emergency funding in an attempt to stabilize the firm; however, the emergency funding was insufficient to address Bear Stearns' immediate liquidity crisis, and the company filed for bankruptcy protection on March 17, 2008. The bankruptcies of both Lehman Brothers and Bear Stearns caused widespread losses in the derivative markets across many businesses globally.
The ripple effects extended well beyond the United States. The UK government announced the takeover of Halifax Bank of Scotland (HBOS) by Lloyds TSB. Losses of approximately $785 million in commercial paper issued by Lehman Brothers made it impossible for the bank to meet its obligations. With over 100,000 creditors globally, Lehman's collapse had an immediate and broad international impact. American International Group (AIG), which was then the world's largest insurance company with over one trillion dollars in assets, also announced that it required emergency loans from the Federal Reserve to survive. AIG had been one of the largest participants in the global CDS market. The collapse of Northern Rock in the UK similarly prompted the European Union, the United States, and Switzerland to take immediate action against the systemic collapse of the financial system. Analysis of the crisis revealed that the United States accounted for 67% of total credit losses, Europe for 29.5%, and Asia for 3.5%.
"Lehman and Bear Stearns bankruptcies escalate crisis"
"Crisis spreads worldwide through trade and financial links"
Raickas, E. and Vasiliauskaite, A. (2011). Channel of financial risks contagion in the global financial markets. Economics and Management, 16.
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