What is a Financial Crisis?

Published by Thomas Herold in Banking, Economics, Investments, Real Estate

'Financial Crisis' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

A financial crisis refers to a period where the value of assets and/or financial institutions declines quickly. Such a crisis is commonly connected with runs on the banks or at the least fear and panic. In these difficult and dangerous economic periods, investors will fire sell any assets they can to pull back their cash out of investment and savings accounts. They do this hoping to repatriate their funds home before they decline or vanish altogether at the financial institution.

Such a financial crisis happens because of assets and banks becoming overly valued. They are typically made far worse because of the inexplicable behavior of mass groups of investors. Often times, a rapid-fire domino effect of selling leads to still lower prices of the associated assets in the crisis and even more bank account withdrawals. If the crisis does not become resolved relatively quickly, it can lead an economy and nation into a deep and painful recession or even a lasting and devastating depression.

The sad part of finance is that it is not only prone to numerous incidents like these, but it is also shaped by financial crisis. There have been many such significant financial crises over the past three hundred years. These included the 1720 South Sea Bubble crisis, the Panic of 1792, the Latin American Crisis of 1825, the Cotton Crisis of 1837, the Railroad Crisis of 1857, the Long Depression of 1873, the Knickerbockers Crisis of 1907, Black Monday and the Wall Street Crash of 1929, the 1973-1974 Arab Oil Crisis, 1987 Black Monday, the Asian Crisis of 1997, and the Dotcom Crash of 2001.

The most recent financial crisis which rocked the international world was the Global Financial Crisis of 2008. Economists have determined that this proved to be the most devastating economic disaster for the world since the 1929 Great Depression which lasted nearly a decade. It led to what has become known as the Great Recession. Strangely enough, while the other financial crises which preceded it could be pinpointed to a main reason or singular event, the Global Financial Crisis could not be.

Instead this economic disaster resulted from a chain of events. Each of these had their own trigger. The crisis was so severe that it nearly caused a complete failure of the American and global banking systems. Economists have made the case that the crisis’ roots dated back to the decade of the 1970s. The Community Development Act proved to be responsible for developing the market for the one-day toxic subprime mortgages. It was this act that mandated banks had to relax their credit standards for those minorities who were lower income earners.

It turned out to be these quasi-government agency guaranteed subprime mortgage debts that expanded dangerously through the early years of the 2000s. Both the primary government sponsored entities Fannie Mae and Freddie Mac were guaranteeing the toxic mortgages. As these loans were booming, the Federal Reserve (American Central Bank) was drastically slashing interest rates after the dotcom crash of 2001 to stave off a national recession from the stock market collapse. In the end, these dual scenarios of cheap money fueled by dramatically lower interest rates and loosened credit requirements brought on by the Community Development Act worked together to create a housing bubble. The ensuing speculation and positive feedback only encouraged home prices to rise still further.

At the same time, the wily investment banks were seeking easy money gains after the 2001 recession and dotcom bust. They invented the fanciful CDOs collateralized debt obligations from mortgages they bought up on the secondary market. By bundling both prime and subprime mortgages together into single instrument investments, they deceived unknowing investors into purchasing highly risky CDO products.

As the CDO market really took off, the housing bubble started bursting. Along with falling home prices, the subprime borrowers started defaulting on their loans en masse. They either could not or would not make payments any longer on those loans that then turned out to be higher than the value of the homes. This only exacerbated the home price decline situation.

Investors next realized that the CDOs they had bought in droves were declining to near worthless. This resulted from the toxic mortgage debt that underlay them. Investors attempted to offload the paper, but they found the market had disappeared. This then led to a perilous wave of subprime lending institution failures. It caused a dry up in liquidity and a subsequent contagion which filtered through to the highest echelons of the banking world and system.

Thanks to their huge exposure to the subprime mortgages and CDO debt obligations, the two enormous investment banks Bear Stearns and Lehman Brothers collapsed without warning. Over 450 other banks then subsequently failed throughout the following five years. Had it not been for a government-administered and taxpayer-funded bank bailout, a few of the mega banks would have failed as well alongside those that did, including such national venerable institutions as Washington Mutual, Wachovia, and Merrill Lynch.

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The term 'Financial Crisis' is included in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.