The 2007-2008 financial crisis began in the United States and was caused by the deregulation of many aspects of the financial world. Deregulation allowed banks to participate in derivative hedge fund transactions. Derivatives were profitable, which led banks to ask for more mortgages; they opted for interest-only loans affordable to high risk/subprime borrowers.
Cheap mortgages prompted consumers to look for housing, which has resulted in a market imbalance as more people invest in real estate. An oversupply of housing on the market led to a fall in housing prices and investors were unable to repay their loans. The value of derivatives fell sharply and later collapsed.
Loans between banks stopped and many of them faced a liquidity problem. Lehman Brothers, an investment bank collapsed and declared bankruptcy on September 15, 2008. The financial crisis in the United States spread to other countries, including the EU, which caused the European debt crisis and a global recession.
In 1999, the Gramm-Leach-Bliley Act withdrew the Glass-Steagall Act, allowing banks to sign two-party contracts, although economists have claimed that such action would prevent banks from competing with foreign institutions and to give only low-risk securities.
In 2000, the commodity futures modernization law allowed for the unsupervised trading of credit swaps, overruling the law citing such an act as a gamble. Several members of Congress insisted on the two projects including Senator Phil Gramm, then Chairman of the Senate Committee on Banking, Housing and Urban Affairs, Alan Greenspan, then Chairman of the Federal Reserve, and Larry Summers, former Treasury Secretary. The use of sophisticated derivatives made the banking sector more competitive and those more complex products generated more profits. Then they bought the smaller banks and declared themselves “too big to go bankrupt”.
The banks issued mortgages that were subsequently sold to hedge funds in the secondary market. The combined mortgage funds combined similar mortgages and computer-simulated models to determine their value using monthly payment plans, probabilities of repayment, real estate prices and probable interest rates.
The hedge fund then sells mortgages to investors. The bank can still lend money because it receives payments from the hedge fund. The bank collects the monthly payment and sends it to the hedge fund, which in turn sends investors, along the chain, deductions in terms of commission.
The transaction posed no risk to the bank, but was risky for investors covered by insurance companies under “credit default swap”. In a short time, many people have embarked on derivatives, including major banks, insurance companies and, in some cases, even individual investors. Banks began issuing high-risk mortgages because they had no risk and had the money to do so.
High loan rates
The recession from March to November 2001 led the US Federal Reserve to lower its policy rate to 1.75% and 1.24% in November 2002. The interest rate on adjustable-rate mortgages was also reduced.
Homeowners who could not afford modern mortgages have access to interest-only loans, and the value of high-risk mortgages has increased from 10% to 20% of the total value of the mortgage. In 2007, high-risk mortgages were valued at $ 1.3 trillion. This created an asset bubble in 2005, when potential investors took out loans to buy houses, not to live, but to own them, while waiting for prices to continue to rise. Many investors were unaware that adjustable-rate loans would be redefined in three years and that the Fed would raise rates to 2.25%, then to 4.25% and in June 2006 to 5.25%.
Housing prices began to fall due to rising interest rates and the inability of investors to sell their assets or repay their loans, which caused an explosion in the real estate market, provoking the banking crisis. 2007, which then spread to Wall Street and other economies causing famous 2008 financial crisis.