The Global Financial Crisis
Reasons for this financial distress trace back to a period of deregulation in the US during the late 1990s, and the financial innovation which helped to drive global sharemarket performance during 2003 to 2007.
Appropriately regulated, innovation can help to produce sustainable growth and shareholder value. But this innovation was not appropriately regulated; it involved 'securitisation' - which is the process of pooling various types of debt and packaging them into investments which were then sold around the world.
Debt included mortgages and credit card payments which were packaged into investments known as 'collateralised debt obligations', or CDOs. These were sold by financial institutions including banks, investment banks and hedge funds. This increased available credit, helping to fund many transactions not previously possible. Some CDOs included subprime loans, or mortgage debt from a particular section of the US housing market. This section is made-up of those home owners who have limited or no income, minimal savings and few assets. These people were offered mortgages to buy property, often at an initial very low rate of interest.
The increase in available credit led to a boom in US mortgage lending and home construction. As more home buyers borrowed more money, the demand pushed house prices higher and higher.
A housing bubble formed in the US. This burst when the US Federal Reserve, concerned about rising inflation during the boom, lifted the official interest rate. This increased loan repayment amounts, which subprime home owners often could not afford. Many people had no choice but to simply walk away from their home.
Conditions worsened as more loans reset from a very low rate of interest to a much higher one. Suddenly, too few homes became too many, and the oversupply caused US property prices to fall sharply.
Problems spread to world financial markets when a number of US banks and hedge funds collapsed. These firms had large exposures to mortgage-backed securities such as CDOs which were re-rated downwards due to coupon payments not being made. Some investors panicked, and banks stopped lending. As modern capitalism relies on credit to borrow and invest, the lack of available credit caused significant problems. In particular, financial institutions lost trust in one another - compounding the halt in loans and available credit - and confidence in global credit markets rapidly deteriorated.