Since the Great Depression of 1929, the financial crisis of 2008 has been the most serious economic catastrophe. As described by the Guardian, the financial crisis is the ‘three weeks that changed the world’. It started becoming noticeable in September 2008 when several large US financial firms began to fail. It led to a recession which is when housing prices fell by more than 30 percent – which was more than it did during the Great Depression. It had many long-term effects, many of which are still present, the unemployment rate in the US was still above 9 percent two years after the recession ended.
Why did this all happen? The US government encourage home ownership. People were buying expensive houses using money from abroad, which caused house prices to increase. Mortgage companies lent money even if the borrower did not have a good credit, these were called subprime loans – they have a higher risk of defaulting. However, after a while housing companies built too many houses which caused the price of houses to decrease (when supply is greater than demand, prices fall) and the value of a lot of the houses decreased below the value of the mortgage debt. This meant that the homeowners were unable to sell their houses – this is what we call negative equity.
By 2007 and 2008, the whole system started to collapse. Banks started to realise that they were holding onto many worthless debt instruments and the US economy started to freeze up. In September of 2008, Lehman Brothers filed for bankruptcy and this was the largest filing in history, and at the time of its collapse it was the fourth largest US investment bank with 25 000 employees worldwide. It had $639 billion in assets and $619 billion in debt.
Banks were bundling up mortgages together and selling the packages to other banks or investors. The packages included mortgages from prime borrowers who would pay back the loan, along with mortgages from subprime borrowers who had a high risk of defaulting. However, the banks were selling these packages as if they only included prime mortgages and were making money. Although this was meant to reduce the risk, it meant that many institutions had bought mortgage packages that were worth less than what they had bought them for. Other countries were also affected from this issue, in the UK the Northern Rock became their first casualty – too many loans were not being repaid so savers started to withdraw their money.
The UK government soon bought Northern Rock (guaranteeing savers their money) and soon bought most of Royal Bank of Scotland and parts of Lloyds Bank. This fall in lending by banks led to a fall in consumer spending and investment leading to a fall in GDP and a rise in unemployment. Due to the rise in unemployment, government spending related to welfare payments (i.e. unemployment benefits) rose. Governments had to rely on institutions such as the European Union to lend them the loans that they needed.