eli5 2008 Global economic crisis
In: Economics
This gets complicated very quickly.
In the early 2000’s there was a huge housing boom in the US. Banks were lending a lot of money (unwisely but that explanation is another long story) and taking on huge mortgage portfolios. So there was a great demand from banks to offload these risks. Some investment firms bought these loans from the retail banks and repackaged them into securities like credit default swaps (CDS) and collateralized debt options (CDO). These securities essentially tried to divide the risk for the loans into smaller bits which could be traded and sold off in smaller bits. AIG (an insurance company) underwrote many of these securities (meaning they insured against the risks) and MANY banks all over the world purchased these securities thinking that they were safe investments. (Details of CDO and CDS are technical)
Unfortunately there was a bit more risk than was understood in these investments and when the housing market cooled off slightly, AIG found out it couldn’t pay out and many banks realized that their investments were not as good as they thought and prices started to fall. According to bank accounting rules, the banks had to reserve (hold more money essentially) against these potential losses meaning they could no longer lend out money. This drove the global financial system into a liquidity crisis.
Bank loans are necessary for many businesses to operate. And businesses trade and do business with other businesses globally. As a result, many companies now ran the risk of bankruptcy when banks couldn’t supply them money even though the companies themselves were not directly involved.
Many governments had to step in and provide liquidity to the financial system by providing emergency loans to banks and forcing a restructuring of banks etc. Several large banks (notably Lehman Brothers) went out of business or were forced to merge. Although the immediate financial crisis was averted, the ramifications was a very real recession in many countries.
Latest Answers