Introduction:

Financial crises are not a decade or century-old problem. It is an ancient pain

point for many countries and rulers. We can trace it from the inflation crises in ancient
Greece to the recent covid crises. It is essential to focus on the causes and aftereffects
of those crises as it provides vital information to the policymakers to avoid or at least
reduce its severity. 2008 global financial crisis was extraordinary in its severity and
the impacted area. It started in the US and spread to the rest of the world. Europian
Countries were severely affected due to their linkage of both sides' institutions and
financial markets. Asian countries got trapped because of the substantial effect on
global trade. It cost a loss of more than $2 trillion to the global growth.
Commercial banks, mortgage lenders, credit rating agencies, investment
banks, and Insurance companies were the major financial players involved in this
crisis. Most of the institutions around the globe had faced the impact caused by the
failure of these institutions: Low-interest rates, ever-rising housing prices, and lousy
advances without substantial repayment capacities and yet highly rated by rating
agencies; all contributed to fuel the bubble. The overfunding led to the increase in
default rate and supply of houses in the market. The increased supply of houses
inversely affected the housing rates and increased default rates. Failure of insurances
burst the bubble and led to the crisis. It led the US to significant reforms in banking
and financial regulations.

Historical Context:
Us economy was dwelling after the attacks of September 11 in 2008. The US
lowered the Federal Funds rate to 1% to boost the economy. Government bonds
became unattractive. It forced investors to look for other higher profit generating
investments. The housing market was one of the attractive and ever-growing markets
of those periods. Institutions used to mortgage loans to individuals taking the house
acting as collateral. The mortgages issued had also been traded with third parties like
investment banks. It served as a reason for large financial institutions to buy these
mortgages to transfer the liquid asset to security. As a result, the monthly repayment
paid by house owners to commercial banks was at the end was directly flowing to
investment banks.
The investment banks used to buy thousands of such mortgages and create
mortgage-backed security for them. This security acted as tranches based on
individual risks, and these tranches were further sold to investors as bonds. These
investors range from pension funds to hedge funds depending on associated risks and
yields. Now the monthly repayment from house owners was rooted in individual
investors. These investments kept increasing as housing prices and its demand
continued to grow. On top of it, credit rating agencies were giving higher ratings to
these securities. Agencies were treating them as a good investment because mortgages
backed them.
The rise in demand for such securities allowed lenders to issue subprime
mortgages to low income and poor credit borrowers. The slack in the process allowed
 unqualified people to get loans without down payments and borrowing beyond their
affordability. Hence these investments became less safe and continued with the same
ratings from rating agencies. These subprime investments made ultimate securities
called Collateralised Debt obligations
(CDS).
The lower interest rates with relaxed lending requirements allowed housing
prices to grow faster. The ease of getting advances increased lending with poor
mortgage securities. It further fueled the housing prices and ultimately formed a
bubble that started busting in 2006. As a result of high risked CDS, some people
could not afford these houses at current prices and defaulted on the loans. With the
increase in defaulting, more houses started getting back into the market. It formed a
cycle. With the continuous increase in supply-demand decreased subsequently
dropping prices sharply. Because of the rapid price drop, some borrowers felt that
mortgage was more than house price and started defaulting.
A substantial increase in bad debt forced lenders to halt subprime loans to
prevent further risky advances. Further, the mortgage securities were backed by
insurance, credit default swaps (CDS). The situation got worse with the insurance
companies. One of the leading insurance corporations, American International Group,
sold such policies worth billions of dollars and assumed that the NPA rate would not
rise above a specific limit. The corporation did not have the required money to back
these policies. Hence failed to provide credits to the buyers.
Adding to the problem, these CDS were further transformed into tradable
securities and involved in massive trading based on the values of mortgage securities.
The overall system formed a web where every institution was interconnected,
and the substantial failure of any instrument could collapse the whole financial
system. The Giant investment institutions like Lehman Brothers go bankrupt. Many
got merged, and some bailed up by the government. Failure of the webbed and
unregulated financial system led to unprecedented losses to the US and global
economies.

References

https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp

https://www.washingtonpost.com/business/economy/a-guide-to-the-financial-crisis--10-years-
later/2018/09/10/114b76ba-af10-11e8-a20b-5f4f84429666_story.html

https://www.britannica.com/topic/great-recession

(PDF) Global Financial Crisis of 2008 and its Impacts. (researchgate.net)