What Caused the Global Financial Crisis of 2008?

We are now living through what many economists believe is the worst economic recession since the Great Depression. The vast number of home foreclosures and business failures, the incredibly low level of consumer confidence, and the high rate of unemployment are unprecedented in most of our lifetimes.

But what caused this global financial crisis to occur?

There are many factors that contributed and no one cause can be said to be solely responsible for a crisis of this magnitude. However, it is generally accepted by most economists that the financial crash was caused by the bursting of the housing bubble that took place in the United States from 1997 to 2006. During this time, average home prices rose from $150,000 to $250,000, an increase of 66 percent.

What caused an increase of this magnitude? Well, it all comes down to one of the most basic tenets of economics: supply and demand. The higher the demand for something, the higher the price will be. From the years 2000 to 2003, to overcome the economic fallout from the dot-com bubble as well as the 9-11 terrorist attacks, the US Federal Reserve lowered the interest rates for bank loans to a mere one percent. Lower interest rates encourage borrowing and of course spending, which drives up prices. One of the primary things people were willing to spend on was houses.

Homebuyers were scooping up houses for sale for upwards of $300,000 (that in reality would have fetched a fair market price of say $225,000 or less) without having ever seen what they were purchasing! These prices paid for houses did not reflect a realistic value for that property; buyers simply became caught up in a buying frenzy of unsustainably valued property.

Sub-Prime Lending

Add to that the fact that mortgage lenders were giving out home buying loans like cheap candy to those who ordinarily would not qualify. This is called "sub-prime lending." These are loans where the banks eventually charge a very high rate of interest and include harsh re-payment terms and penalties in order to make up for the higher risk inherent in these loans. To entice more homebuyers to borrow money, however, the initial interest rates are very low, lower that what they should have been considering the borrowers' credit rating, some as low as the one percent enjoyed by much more qualified borrowers. But sub-prime loans are variable-rate loans, meaning the interest rates can go up, and go up they did.

Likewise, all good things usually come to a quick end and the Fed increased interest rates. This reduced the desire to borrow money for the purpose of purchasing homes and, as a result, housing prices began to decline, in some areas of the country quite dramatically. This is known in economics as an "adjustment," meaning the market corrected itself and more realistic fair market prices began to be paid for houses. In common terms, the bubble had burst.

Rampant Foreclosures

This left many new homebuyers living in a house they had paid far more than a realistic price for and with a mortgage with an interest rate that in some cases was more than 10 percent for high-risk borrowers. This in essence resulted in homeowners owing their banks far more than their house would ever be worth. This encouraged many to simply walk away from their homes and hefty mortgages, entering into foreclosure. After a number of people defaulted on their loans, this put a huge strain on the US banking system.

But banks don't exist in isolation. They often package their borrowers' debt into what are known as mortgage-backed securities and sell them to other investors, some of whom are headquartered in nations all over the world. Ordinarily, this is not a problem at all, and the risks are no greater than with any other investment. However, the large number of sub-prime mortgages packaged into the mortgage-backed securities greatly increased the risk and so with the collapse of the US housing bubble came a plummet in the values of securities tied to US real estate prices. This greatly damaged financial institutions globally.

Despite government-sponsored bailouts of financial institutions and of stimulus packages, the economies of many nations worldwide have suffered greatly. Though predicted by some economists to last only 1.5 years, hard economic times have stubbornly pervaded for almost four years now, with no end in sight.