When Finance Ate Itself
The Global Financial Crisis (GFC, 2007-2009) was the worst disruption since the Great Depression. It was a crisis of leverage, complexity, and contagion that caused global output to contract.
Prices doubled from 1997-2006, fuelled by subprime mortgages—loans to borrowers with poor credit. Banks bundled these into mortgage-backed securities (MBS) and sliced them into tranches. Credit agencies slapped AAA ratings on top tranches, masking the toxic risk inside.
Banks borrowed 30 to 40 times their equity. A tiny asset drop wiped their entire buffer:
Common pitfall: Blaming subprime borrowers. Subprime losses alone were absorbable; leverage and opacity turned a housing correction into a global cardiac arrest.
Amplifiers and Policy
When one bank fell, wholesale funding vanished and the interbank market froze, turning a local drop into worldwide contagion.
| Amplifier | Mechanism |
|---|---|
| Leverage | Banks at 30:1, a 3% asset fall wipes equity |
| Securitisation | Risk repackaged until nobody could price it |
| Wholesale funding | Overnight money vanished in a run |
| Contagion | Interconnection turned one failure into panic |
Depression lessons halted total collapse via aggressive policy:
- Monetary: Fed rate cuts to zero and quantitative easing (QE) to inject liquidity.
- Fiscal: Stimulus packages replacing private demand.
- Financial: Bank bailouts and the Dodd-Frank Act (2010) raising capital requirements.
US GDP fell 4% and unemployment hit 10%. Taxpayers funded bailouts, and trust plummeted.