Global Financial Crisis



Global Financial Crisis

Introduction

Financial crises have intervened the operation of financial markets over years. Most noticeably the great depression in 1929-30, the 1970s inflation crises and the banking crises in the 1990s created havoc in the financial markets causing severe disruption. The current financial crisis which emerged in 2007, although the roots were sown much earlier, has been one of the toughest and probably the biggest that financial markets have ever encountered. Referred to as the credit crunch, the impact of the crisis has not only been on the banking sector but on the real economy as a whole potentially leading to long and deep recession.

Causes of the Financial Crisis

Numerous accounts have been made to explain the causes of this great financial disaster. There are a number of compounded factors that has resulted in the outbreak of this financial crisis of enormous proportions. Collapse of the US housing market, highly leveraged financial transactions and a low interest rate encouraging borrowings, among others, have all contributed to the downturn in the global financial market. Let us now look at these various causes in greater detail.

Low Interest Rates

Following the burst of the dot com bubble and the possibility of recession looming the US government started reducing the interest rates to boost up the economy. The interest rate became as low as 1.5 percent in June 2003 which was at its lowest level since 1958 (PSB, 2007). This low interest rate found its takers in the form of home buyers and borrowers with the housing market finally showing some growth after years of declining trend. In fact the rate of a 30 year fixed rate mortgage in the year 2003 was the lowest in forty years and so the dream of owning a house in US was becoming a very easy reality for a lot of Americans (Investopedia, 2007). With housing prices increasing borrowers felt that the rise in the prices would cover the principal and the interest payments to be made over time. The possibility of making capital gains by selling it in the future also attracted a lot of buyers due to the low interest rates provided by banks.

The real estate bubble and the subsequent collapse

The US housing market witnessed great boom during the 1997-2005 period due to excessive (careless, as well) lending by banks and the low interest rate, described above. According to the S&P/Case-Shiller national home-price index, American house prices rose by 124% and British house prices increased by 194% during the period 1997 and 2006 (Economist, 2007). The stories were similar in other countries in Europe and Asia as well. In the US homeownership rates rose for all regions, all age groups and all income groups during this period (Shiller, 2008). The US government deliberately encouraged home ownership, which if carried out well reflects good governance and administration. However, if the same policy is carried out carelessly it can lead to great distress and problems (Shiller, 2008).

The low interest rate coupled with rising housing prices made banks ...