The term financial crisis is applied broadly to a variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults.Financial crises directly result in a loss of paper wealth but do not necessarily result in changes in the real economy. Many economists have offered theories about how financial crises develop and how they could be prevented. There is no consensus, however, and financial crises continue to occur from time to time 2
Stages in the crisis
The financial crisis has unfolded in overlapping stages.
• The mortgage crisis. Low interest rates in the early 2000s encouraged many Americans to buy homes. As a result of the increased demand, home prices doubled during the decade ending in 2006, leading to increasing odreal estate prices that would continue to rise indefinitely. Investors from around the world, eager to profit from this steady price climb, bought new investment products tied to mortgages. So many people wanted to invest in these products that, in order to satisfy them, more and more mortgages had to be sold. But the number of would-be home-buyers with good credit was limited. Banks therefore relaxed their lending standards, and encouraged people who would have been turned down for loans a few years earlier to borrow more than they could afford, or to take out adjustable rate mortgages with low initial interest rates but automatic rate increases that not all customers understood. Many of these borrowers couldn’t keep up with their payments. When home prices eventually fell, some people found that they owed more on their mortgages than their houses were worth; many responded by stopping their payments. • The credit crunch.
Before the housing bubble burst, Americans took on more debt than ever before, in the form of mortgages, home equity loans, car loans, and credit card debt. The biggest investment banks took on more debt, too—making them more vulnerable when the economy took a downturn. As more people failed to pay back their loans, mortgage-related investments lost value. Lenders found themselves with much less money to lend; it became harder for businesses and individuals to get loans, which slowed economic activity in general. In response, the Federal Reserve (the central bank of the U.S.) cut its base interest rate to nearly 0%, and the government lent billions to banks to enable them to start lending again. The government neglected to require that the funds be used for lending, however, and many banks used the money instead to pay debts and acquire other businesses.
• Bailouts for companies “too big to fail.”
the Big Three American auto manufacturers—GM, Ford, and Chrysler—came close to bankruptcy. (The main reasons: fewer people were buying new cars, and many of those who did chose smaller, more fuel-efficient foreign cars; and Detroit’s labor costs, including the cost of pensions for retired workers, far exceed those of its foreign competitors.)In order to protect these companies from going out of business (which would have cost up to 3 million jobs and undermined confidence in the entire U.S. economy), the federal government lent GM and Chrysler billions of dollars and forced them to undergo restructuring. The financial crisis became President Obama’s first priority once he took office. • Global recession:
The crisis has spread far beyond our borders. Several European banks invested heavily in mortgage-backed securities, and their losses put some of them out of business. Many countries have turned to the International Monetary Fund, an agency of the U.N., for emergency aid. All around the world, lack of money available for loans has...
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