Financial systems are the very foundation and heart of a free market economy. Therefore, it is not surprising that the financial crisis witnessed in 2007 to 2008 sent panic waves globally as investors and governments realized the possibility of the total collapse of the world’s economic system. With the proliferation of new financial instruments, the calculation of market values had become not just complicated, but almost impossible. Consequently, calculating the value of institutions that held the securities became impossible. This was the genesis of the financial depression witnessed from 2007 to 2008, which resulted in grave consequences to the world’s economy. The 2007 financial crisis cannot be blamed on a single entity. Rather, it was a result of the collective responsibility of lenders, investors, homeowners, and national central banks. The fall of Northern Rock in August 2007 shocked the world. As people struggled to understand the cause of the fall of such an established institution, it later emerged that it was the beginning of a historic financial landslide. Many big companies fell while the ones left standing struggled. There were many possible causes of the economic crisis. However, the main disaster which later triggered a series of others across the globe mainly affecting European Nations and institutions that traded in new financial instruments happened in the United States residential mortgage market. The September 11 terrorist attack, coupled with the dot-com bubble had put the US economy at risk of the great recession. United States Federal Reserve System embarked on an economic stimulus program to avert the looming recession. The program involved the creation of capital liquidity through the reduction of effective interest rates. Investors intending to maximize return on their capital sought investments in risky ventures which promised this desired return. Lenders equally became “generous” and took great financial risks by approving mortgage loans to persons with questionable creditworthiness. This led to a massive increase in demand for housing as even unemployed persons could secure bank loans. Unfortunately, no one warned of the possible consequences of the “take now pay later” mortgages.
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Several factors emerged that rendered the once sweet deals bitter pills to happy homeowners. It all began when the interest rates that had hit an all-time low of 1% started rising. The rise in interest rates was so drastic that in just a year, it had peaked at 5.25%. Worst still, homeownership was already saturated and no new buyers were available. This resulted in a steady decline in home prices rendering the once valuable assets almost useless. Homeowners did not only face the challenge of their property devaluating but had to pay a lot of money due to increased interest rates too. This led many to default on their repayments. As more and more borrowers failed to repay their loans, the lenders began to run short of cash thereby filing for bankruptcy. February 2007 witnessed the highest number of subprime lenders, 25, filing for bankruptcy. These developments set the tide rolling as the financial markets faced more and more challenges.
The crisis was made worse by the huge funds involved, which even with governments’ intervention was hard to restore immediately. Financial firms and hedge funds had given out more than $ 1 trillion to borrowers. This amount alone was enough to cause economic ripples across the world! In 2007, it became clear that the subprime problem was beyond the financial markets as it spread to other countries.