The Global Financial Crisis

When Finance Ate Itself

The Global Financial Crisis (GFC, 2007-2009) was the worst financial disruption since the Great Depression. US housing prices fell, mortgage-backed securities collapsed, major banks failed or were rescued, credit markets froze, and the real economy contracted worldwide. It was a crisis of leverage, complexity, and contagion.

The housing bubble: US house prices doubled between 1997 and 2006, fuelled by low interest rates, lax lending standards, and the belief that prices could only rise. Subprime mortgages — loans to borrowers with poor credit — proliferated because they could be bundled, securitised, and sold to investors who didn't know (or care) what was inside.

Securitisation and complexity: banks packaged thousands of mortgages into mortgage-backed securities (MBS), then sliced those into tranches rated by credit agencies. The top tranches got AAA ratings — the same as government bonds — despite being backed by risky loans. When the underlying mortgages defaulted, the securities collapsed, and the ratings proved worthless.

Leverage: banks had borrowed 30 or 40 times their equity to buy these assets. A 3% fall in asset value wiped out the equity buffer. Lehman Brothers, Bear Stearns, AIG, and others were leveraged to the point where any decline was fatal.

Contagion: banks lent to each other; when one failed or looked shaky, the entire interbank market froze. Credit stopped flowing — not just to banks, but to businesses and households. The financial crisis became a real-economy crisis: GDP fell, unemployment surged, trade collapsed.

$$\text{Leverage} \times \text{opacity} \times \text{interconnection} = \text{systemic risk}$$

Policy response — Depression lessons applied:

• Monetary: the Fed cut rates to zero and launched quantitative easing (QE) — buying government bonds and MBS to inject liquidity directly.
• Fiscal: stimulus packages (US, Europe, China) replaced collapsed private demand.
• Financial: bank bailouts (TARP), stress tests, and eventually the Dodd-Frank Act (2010) tightened regulation, raised capital requirements, and created resolution mechanisms for failing banks.

The GFC was not a repeat of the Great Depression — because the Depression's lessons were applied: lender of last resort, deposit insurance, fiscal stimulus. The recession was severe (US GDP fell ~4%, unemployment peaked at 10%), but the system did not collapse. The cost was borne differently: taxpayers funded bailouts, savers lost returns to low rates for a decade, and trust in financial institutions fell — generating its own political consequences.

The amplifiers of 2008

Common pitfall: Blaming subprime borrowers for a systemic crisis. The losses on subprime alone were absorbable; leverage and opacity turned a housing correction into a global cardiac arrest.