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Causes and Events of the Global Financial Crisis

The global financial crisis has caused millions of people to lose their jobs. It has also cost countless families their homes, and it has wreaked havoc on many countries around the world.

Too-big-to-fail Financial Institutions

Too big to fail is a term used in the finance industry to describe financial institutions that have become so large that if they fail, they could threaten the integrity of the entire financial system. This threat has become a perennial concern. The United States has suffered several instances of such institutions failing. Although they continue to operate today, the financial crisis has caused the largest financial firms to grow much larger than they were before. However, regulators have not been using meaningful metrics to assess the risk of such institutions. Moreover, too big to fail banks remain highly connected to other parts of the financial system.

During the subprime mortgage crisis, many large banks were at risk of bankruptcy and needed government intervention to prevent economic collapse. These actions were taken to restore consumer confidence and stabilize the financial markets. Despite these measures, however, many banks still failed. One of the largest of these firms was Lehman Brothers, which filed for bankruptcy in September 2008 (Skeel, 2018).

Unscrupulous Investment Banking and Insurance Practices

The 2008 global financial crisis (GFC) was the biggest calamity to hit the banking and financial services industry since the Great Depression. The recession, which affected a number of countries around the globe, was the worst recession in more than a generation, resulting in millions of jobs lost and millions of dollars in bankruptcies (Duignan & Bondarenko, 2009). While the US was hit particularly hard, Europe, Japan, and Australia all experienced significant downturns. This was due to the various vulnerabilities of the private and public sectors. Some of the most prominent developments included the subprime mortgage meltdown and the rise of non-bank lenders such as hedge funds, insurance companies, and asset backed commercial paper (ABCP) vehicles.

As a result of the numerous vulnerabilities, the specter of a massive banking collapse became a reality. One of the more notable events was the failure of Lehman Brothers. While it didn't bring down the banking system on its own, it was an important step in reorganizing the industry. Other key developments include the emergence of a shadow banking sector that depended on short-term wholesale funding, such as commercial paper and repurchase agreements, to stay afloat.

The most obvious culprit was the housing market. When mortgage rates increased, many home buyers found themselves with more debt than they could handle. However, when house prices declined, they didn't have enough equity to cover their bills. In the worst-case scenario, they went into default, a scenario that was exacerbated by the fact that many mortgages were based on exotic mortgage instruments, such as adjustable-rate mortgages and interest only loans.

A number of other factors were involved. For example, an increasing number of large firms failed to properly track their risk exposures. Many of these institutions also relied on government support to get them through a bad patch. These entities also lacked the foresight to devise more resilient funding sources. And, while it's true that the housing market had its ups and downs, the GFC was a particularly bad year for the industry.

Nevertheless, there is no denying the plethora of factors that contributed to the GFC. As one of the largest financial systems in the world, the US had to face some serious challenges. Despite its best efforts, many banks failed to survive the downturn, requiring government assistance to bail them out. To compound the problem, many were too big to fail. This is not to say that all banks were incompetent; it's simply that they all had to be smarter about their lending decisions.

During the heyday of the housing bubble, many people took on more debt than they could afford, especially when combining that debt with a mortgage. In a nutshell, the financial crash was a product of over-leverage, bad underwriting, and a lack of regulation.

Credit Default Swaps

Credit default swaps are an insurance product that can be bought and sold to reduce the risk of investing in bonds and fixed income products. These are derivatives that are traded in an unregulated, over-the-counter market (Aldasoro & Ehlers, 2018). The financial crisis of 2007-2008 was triggered by the collapse of the investment banks.

In the aftermath of the 2008 financial crisis, credit default swaps became the focus of many observers. They are used to insure against losses incurred by companies in the event of a default on loans or other debt. It is a way for borrowers to protect their money against risks, and it is considered to be a useful tool in the choppy world of economic turmoil.

Credit default swaps were developed in the early 1990s to protect against losses on mortgage-backed securities, and were largely used during the European sovereign debt crisis of 2007. A credit default swap is similar to an insurance contract, in which the seller of the swap agrees to pay the buyer for a loss on a specified asset, such as a bond. There are a few variations on the concept, including physically settled and cash settlement.

While a credit default swap is an excellent way to insure against a possible loss, they can also be a source of financial problems if the underlying asset does not perform as expected. As such, the performance of the CDS market is closely related to changes in the credit spreads.

During the 2008 financial crisis, there was an enormous amount of volatility in the market. This led to an increase in trading volume for index-credit-default swaps. Currently, these products are up 68% year-to-date.

In the early years of the global financial crisis, swaps were unregulated and not a lot of people understood what they were. However, they became an important tool in the development of synthetic CDOs, or collateralized debt obligations, which were essentially a way for investment banks to sell complex financial products.

While credit-default swaps were a contributing factor to the financial crisis of 2007-2008, they did not cause the crisis in a dramatic fashion. Although the market was largely unregulated during this time, it operated fairly well. Moreover, the majority of financial institutions that sold swaps were undercapitalized. That made the system vulnerable to failure.

In the event of a crisis, many credit default swaps were picked up by taxpayers. These are mainly used to insure against loss on mortgage-backed securities, but they are not visible on the balance sheets of financial institutions.

However, during the financial crisis, a large number of underlying credit instruments failed and large banks had to file for bankruptcy. In the end, it was the Federal Reserve that helped to bail out the insurers, including American International Group.

Examples of Financial Crisis Events and Their Impact on Financial Markets

During the Global Financial Crisis (GFC), hundreds of trillions of dollars were lost. Many people lost jobs, homes, and wealth. Despite a strong policy response, the US economy suffered a slow recovery.

The US government was able to save Lehman Brothers by using public money. However, the rescue plan will affect the government's budget. Another major issue is how the market will react to the plan.

The failure of Lehman Brothers set off a global financial crisis. Governments intervened to prevent the spread of the crisis and to restore liquidity in the banking system. Central banks injected more liquidity into the system. These steps did not stop the global financial crisis. The United States rescued American International Group, the largest US insurance company.

Another example of a too-big-to-fail financial institution was Continental Illinois National Bank and Trust, which experienced a high-speed electronic bank run in 2007. Eventually, the Federal Deposit Insurance Corporation took control of the bank (History of the 80s). It remained there until January 2008.

In 1972, the Detroit-based Bank of the Commonwealth was in trouble. At that time, the United States federal mortgage agencies were offering subprime loans to individuals who were unable to pay them back. When the mortgage market collapsed, the U.S. Federal Reserve offered a $30 billion loan to JPMorgan Chase & Co. to buy the bank.

Several other systemically important banks also failed during the 2007-2008 global financial crisis. For instance, Fannie Mae, Freddie Mac, and Lehman Brothers all went under. Many of these failed institutions had significant consequences for the national and global financial systems (The 2007–2009 financial crisis and other financial crises 2019). Hence, it is not surprising that governments would step in to save them. Governments in the US and Europe spent more than $679 billion to recapitalize these banks. They supplemented their capital injections with numerous asset-support programs and liability-guarantee programs.

The Scale and Impact of the Global Financial Crisis on the Economy of Three Different Countries

The global financial crisis (GFC) was a shock to many people. It was the most severe recession since the Great Depression and a key indicator of how interconnected the nation-states and their institutional orders have become.

While it was a global financial crisis, the effects of the GFC were uneven across the world. For instance, many advanced economies experienced a decline in growth. In contrast, emerging economies were better prepared to deal with the crisis (Lane, 2012). However, the crisis had a much broader impact on the world, with unemployment skyrocketing to over 200 million.

A key lesson from the global financial crisis is to prepare. This should involve countries limiting their vulnerabilities. Among the measures, countries should focus on maintaining a strong economy. And they should be careful not to allow their institutions to weaken.

Some countries were able to adopt countercyclical policies and limit the damage from the crisis. However, most of them did not have the capacity to do so. Instead, they were susceptible to contagion. Nonetheless, citizens of all nations have a common interest in the quality of economic policies in other countries.

Another important factor in the global financial crisis was the impairment of key US capital markets. This was contained by unorthodox central bank actions and backstop funding from national treasuries. Still, it is unlikely that the global financial system can be completely restructured to limit the damage from the crisis.

Likely recurrence of Global Financial Crisis

The Global Financial Crisis has come and gone, and it is likely that we will not see a repeat. But while it was a devastating event for the global economy, there are lessons that can be learned from it.

Nonfinancial corporate debt has grown by more than $66 trillion in mid-2017. Two-thirds of the growth has come from developing countries (McKinsey Global Institute, 2018). There are concerns about the potential for more defaults from this type of debt.

From a financial standpoint, the system as a whole is much more stable, and the plans for handling a failure are more stable (Khare, 2022). The 2008 financial crisis was a rare event, and financial systems have improved since then.

To conclude, the great financial crisis of 2008 was a phenomenon in and of itself, and it is highly unlikely that it will occur again, despite the possibility that the world will experience monetary issues in the years to come. This is probably due to the fact that recessions are a normal part of an economic cycle.

References

“The 2007–2009 financial crisis and other financial crises” (2019) Contemporary Financial Intermediation, pp. 331–352. Available at: https://doi.org/10.1016/b978-0-12-405208-6.00014-0.

Aldasoro, I. and Ehlers, T. (2018) The credit default swap market: What a difference a decade makes. Available at: https://www.bis.org/publ/qtrpdf/r_qt1806b.htm (Accessed: January 15, 2023).

Duignan, B. and Bondarenko, P. (2009) Great recession . Available at: https://www.britannica.com/topic/great-recession (Accessed: January 15, 2023).

History of the 80s (no date). Available at: https://www.fdic.gov/bank/historical/history/ (Accessed: January 14, 2023).

Khare, A. (2022) Will the financial crisis of 2008 repeat itself? Available at: https://groww.in/blog/will-the-financial-crisis-of-2008-repeat-itself-here-is-a-detailed-analysis (Accessed: January 14, 2023).

Lane, P.R. (2012) Financial globalization and the crisis - bank for international settlements. Available at: https://www.bis.org/events/conf120621/lane.pdf (Accessed: January 14, 2023).

McKinsey Global Institute (2018) Decade after the Global Financial Crisis: What has (and hasn’t) changed? Available at: https://www.mckinsey.com/~/media/McKinsey/Industries/Financial%20Services/Our%20Insights/A%20decade%20after%20the%20global%20financial%20crisis%20What%20has%20and%20hasnt%20changed/MGI-Briefing-A-decade-after-the-global-financial-crisis-What-has-and-hasnt-changed.ashx (Accessed: January 14, 2023).

Skeel, D. (2018) History credits Lehman Brothers' collapse for the 2008 financial crisis. here's why that narrative is wrong. Available at: https://www.brookings.edu/research/history-credits-lehman-brothers-collapse-for-the-2008-financial-crisis-heres-why-that-narrative-is-wrong/ (Accessed: January 15, 2023).

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