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Financial crises have persistently occurred throughout history originating back to the creation of early empires and formation of colonies. Their appearances can sometimes be unanticipated. Nevertheless, crises can be controlled from escalating into more threatening and severe situations such as depressions by implementation of rules and regulations. The global economic crisis of 07-08 mainly arose as a result of a significant reduction of financial regulations that were implemented during the Great Depression era with the intent to stabilize the economy and prevent future economic disasters from reoccurring. Its origins can be traced in the United States to the low interest rate policies enforced by the government itself to encourage home ownership, and the introduction of many risk-taking techniques such as derivatives, which were bets made on the creditworthiness of a specific company. Other countries such as Iceland, Japan, Spain, U.K and many more also adapted these tactics, which later resulted in unfavorable outcomes to their economies.
In 1999, congress passed the “Gramm-Leach-Bliley Act” which inverted the Glass-Steagall Act. The Glass-Steagall Act was passed in 1933 in order to prevent banks from engaging in risky activities such as speculating with depositors’ savings and affiliation with other firms. This change in regulations enabled many investment banks to operate profusely as they started entering a new global financial liberalization era. Greed and dissatisfaction were the early stimulators that contributed in the attrition of confidence that profits will remain at low levels. As a result of deregulation, products such as derivatives were invented and quickly introduced to the market to which Warren Buffett refers as weapons of mass destruction. Credit default swaps and collateralized debt obligations were the most common ones. This led into the development of the securitization process, where the party who makes the loan does not get affected if there is a failure to repay by the borrower. This was mainly because the lenders sold the mortgages to Investment banks. The investment banks then combined these mortgages with other loans such as car loans, credit card loans, and student loans.
This resulted in the formation of the collateralized debt obligation or CDOs, which were sold to investors around the world. Since all these products were rated triple A or the highest investment rating from rating agencies, many investors perceived them as risk free safe investments. Lenders started making riskier loans since they had no liability in terms of them going bad. Investment banks on the other hand ignored the instability of the loans since their primary focus was to maximize their profits by selling more CDOs, which ultimately contributed to a higher increase in predatory lending. Credit default swaps were another form of derivatives. They were insurance for investors regarding their purchased CDOs. Insurance companies like AIG were the main service providers and promised to pay any losses to investors in case the CDOs went bed.
Another important fact to keep in mind is that in the derivatives market other speculators can also buy insurance for a CDO they do not own. This put the insurance companies in greater risk after they became responsible for covering the losses of more than one party. Many investment banks started betting against their CDOs indicating that they were going to go bad. As a result of the derivative market being unregulated, insurance companies were not obligated to report any amounts of money set aside in order to cover the losses if any were incurred. This exposed AIG and many other insurance companies to high levels of risk, which later translated into a catastrophe. In early 2007, the situation intensified and panic started to gain ground on a high scale. As credit strains became atrocious, the economic activity started to deteriorate. Lenders’ cautiousness and not extending additional credit was followed by massive defaults on loans and bankruptcy filings since many institutions worldwide started facing liquidity issues and became unable to pay their obligations. A GDP decline was quickly noticed in many countries especially in Europe and East Asia. This was mainly due to the collapse in consumer confidence, low demand for goods, and a decline in production worldwide. Unemployment quickly skyrocketed, as many companies tried to mitigate the threat of bankruptcy by laying off large amounts of their employees. Unemployment rate reached an all time high in certain european countries where it passed the 27% mark.
On the other hand, China, the second largest world economy was mainly impacted by a decline in world trade considering its high exporting role. The financial crisis of 07-08 is recognized as one of the most severe and painful financial crisis to have attacked the world economy in the years post Great Depression. Currently, many governments worldwide have taken pre-cautious actions toward regulation and many new policies are implemented in order to stabilize the economy and prevent future crisis. The United States of America, the epicenter of 07-08 financial crisis, is now following a more regulated approach with the intent to substantially ameliorate the consequences that is currently facing.