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THE INVESTOR
25TH ANNIVERSARY
It started in the US housing market.When the derivatives market ran
into trouble, the contagion spread worldwide.Ten years later,we’re still
recovering from the financial hangover...
RASHCR
t has been nearly a decade since the world
succumbed to its worst economic crisis in the
post-war era.The crisis, which began in 2007
and had its most devastating phase in 2008–9
when large parts of theWestern banking
system had to be rescued by governments,
still casts a long shadow.
It can be seen in the fact that the official
interest rates set by the major central banks
are still at rock-bottom, near-zero levels.
It can be seen in the fact that those central
banks resorted to‘unconventional’monetary
measures, including quantitative easing (QE),
some of which has yet to be reversed.And
it can be seen in disappointing post-crisis
growth rates, which have had political and
economic ramifications. Some would even argue that there is a
direct line from the crisis to the UK’s Brexit vote and the election
of President Donald Trump in the US.
The causes of the crisis were many and varied. Its immediate
cause was that poorly understood derivatives linked to the US
housing market, and in particular to‘subprime’mortgages , had
spread around the global financial system.On one calculation at
the time, a single $135,000 US subprime mortgage supported
as much as $5 billion of derivatives
1
.These instruments were
held by banks around the world in the belief that they were safe,
AAA-rated investments, offering a decent return.The‘search for
yield’, as investors sought out above-average returns in an era of
low interest rates, drove the banks into instruments which, on the
face of it, were inherently risky but which were given a clean bill
of health by the ratings agencies.
When the US housing market slump began in 2006, these
instruments were found not to beAAA after all, but no better than
junk status.This sparked panic, particularly in 2008.The banking
systemwas suddenly sitting on huge losses.The problemwas
spread so widely that normal banking activity dried up – banks
could not trust others they were dealing with. Governments had
no choice but to step in.
The subprime issue was not the only cause of the crisis; there
had been a prolonged rise in private-sector debt in the preceding
years.Other contributory factors were economic imbalances –
some countries were running large balance of payments deficits
and some had equally large surpluses – and what became known
as the‘global savings glut’ (produced by high savings in countries
such as China), which put downward pressure on interest rates.
This is why, perhaps, the crisis has had such a long legacy.The
banking hangover, during which bank balance sheets had to be
repaired and capital buffers built up, combined with the fiscal
hangover that resulted, in part, from bank rescues but mainly from
the deep recessions thatWestern economies suffered in 2008–9.
BY DAVID SMITH
THE GLOBAL FINANCIAL CRISIS