The Global Financial Crisis 5th anniversary: All you ever wanted to know

Oct 25 2013, 16:34 IST
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The meltdown originated in the sub-prime mortgage crisis in USA in 2007. The meltdown originated in the sub-prime mortgage crisis in USA in 2007.
SummaryYears that preceded turbulence saw an exceptionally strong performance of the world economy.

in US had been rising rapidly since the late 1990s and investment in housing had assured financial return. US home-ownership rates rose over the period 1997-2005 for all regions, all age groups, all racial groups, and all income groups.

The boom in housing sector made both banks and home buyers believe that the price of a real estate would keep going up. Housing finance seemed a very safe bet. Banks went out of their way to lend to sub-prime borrowers who had no collateral assets. Low income individuals who took out risky sub-prime mortgages were often unaware of the known risks inherent in such mortgages. While on the one hand, they were ever keen to become house-owners, on the other, they were offered easy loans without having any regard to the fact that they were not in a position to refinance their mortgages in the event of the crisis. All this was fine as long as housing prices were rising. But the housing bubble burst in 2007. Home prices fell between 20 per cent and 35 per cent from their peak and in some areas more than 40 per cent; mortgage rates also rose. Sub-prime borrowers started defaulting in large numbers. The banks had to report huge losses.

- Excessive Leverage

The final trigger came from excessive leverage. Investors bought mortgage-backed securities by borrowing. Some Wall Street Banks had borrowed 40 times more than they were worth. In 1975, the Securities Exchange Commission (SEC) established a net capital rule that required the investment banks who traded securities for customers as well as their own account, to limit their leverage to 12 times. However, in 2004 the Securities and Exchange Commission (SEC) allowed the five largest investment banks – Merrill Lynch, Bear Stearns, Lehman Brothers, Goldman Sachs and Morgan Stanley – to more than double the leverage they were allowed to keep on their balance sheets, i.e. to lower their capital adequacy requirements.

* The Meltdown

Initially started as a liquidity problem, it soon precipitated into a solvency problem, making US financial institutions search for capital that was not readily available. Bear Stearns was sold to the commercial bank J.P. Morgan Chase in mid-March 2008; Lehman Bros filed for bankruptcy in mid-September 2008; Merrill Lynch was sold to another commercial bank, Bank of America and finally Morgan Stanley and Goldman Sachs signed a letter of intent with US Federal Reserve on September 22, 2008 to convert

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