Simply, how does it happened (financial crisis) ?
Let’s take some interesting examples of the main crisis that happened in the US before 2007 which related in someway to the recent financial crisis:
1- The Great Depression (1929): It was granddaddy, longest and most extensive crisis in the US history. Many sectors suffered during this crisis, mostly the stock market. Experts have not agreed on the exact reasoning behind it; there are differences in analysts’ view. One of the strongest views emphasized that the crisis started as normal; however, Federal Reserve policies contracted the money supply which caused the situation to be exacerbated. The idea of Fannie and Freddie started after this depression, which has a strong impact on the 2007 crisis.
2- The Dot-com Bubble “I.T Bubble” (2001-2002): At that period of time, many people were attracted to the technology companies because of the great improvement and accomplishment they achieved year after year, especially when Google came on the scene in 1999-2000 and achieved fast and great technology improvements and gained huge profits. As a result, people tend to buy companies’ stocks that have dot-com at the end of its name, as believing of the technology strong future. Later on, it is reality that markets correct prices sooner or later, and the dot-com bubble burst to cause an open fall in the stock market especially in the technology stocks. The related issue of this crisis to the 2007 crisis is that Federal Reserve had reduced the interest rate as a helpful way to stop more loss, which attracted many big investors to invest their money in the US market after that year.
3- Sub-prime Crisis “Mortgage Crisis” (2007): After termination The Dot-Com Bubble and making a substantial improvement in US market, and because of the decrease in interest rate many countries, like China and the oil-exporting countries in the Middle-East, invested their money in the US market and banks. As a result, US banks got a large amount of liquidity from leading depositors who were expecting fair value from the US market. Later on, and as a result of more drop in the interest rate in 2003, a new phenomenon appeared on the scene when banks found it a brilliant opportunity for investing that huge amount of money by giving sub-prime mortgages to borrowers. Banks thought it was a less risky option with high return. Unfortunately, banks were unconcerned about the quality of the customers because most of them do not meet standard criteria for acceptable credit quality, such as credit history, repayments ability or good income.
Later, when banks found out that they hold mortgages more than liquid money they started to move in securitization order by classifying these mortgages to three levels, AAA, BBB, CCC, and sell them as assets to mortgage companies, like Fannie and Freddie, who own almost 90% of the US’s secondary mortgages. Mortgage companies started to sell these assets in the market as securities, but as a safe side they covered them in the large insurance companies, like AIG. Because of the government-sponsored enterprise, like Fannie and Freddie, sub-prime mortgages grew from $173 billion in 2001 to reach $665 billion in 2005 which indicates that the mortgage bubble is going to explode one day. At that moment two issues should be considered, in one hand, banks were still giving more easy mortgages-loans which cause houses price to continue rising. In the other hand, sub-prime borrower credit scores also raised causing many borrowers to experience difficulties in repayment, however, because houses prices were still valuable they found it an opportune time to sell their houses and pay their loans back.
This environment led many houses for sale which cause the houses prices to slow down, and then turned to negative in many states. Later on, more borrowers became unable to meet their mortgage repayments because of the raise in the interest rate from 1% in June 2003 to 5.25% in June 2006; furthermore, they discovered that their loans are much more expensive than their houses prices and it does not make any sense to continue paying their loans, they decided to stop paying their loans and return their houses to the banks, which causes banks to be shifted from easily available credit to tight credit which caused the situation to be worse, because many businesses defected for lack of liquidity, so they started to sell their assets in the stock market cheaply to obtain liquidity, and that causes an open fall in the US stock market. Also, deterioration of real estate prices and borrowers defaults in repayment caused a huge negative impact on many sectors, like mortgage companies, insurance companies, banks and holders of mortgage securities.
Finally, we should acknowledge that there is no single entity to blame in this crisis, because those problems were like dominoes each one has an impact on the other. Even experts have different views, some blamed Federal Reserve policies, others blamed the government-sponsored enterprise which encouraged banks to provide more mortgages loans, and some said it because the greed of banks to increase their profits rapidly. In this stage, it is regrettable to note that banks were acting with confidence because they had always believed in the following statement “If anything happened the government will be there to catch us, because if we go down the country goes down!”, and this is what exactly happened later.
