3.
2 Economic Impact of the Crisis
The 2007-2008 Financial Crisis had widespread
consequences, including:
High Unemployment Rates: Millions lost their jobs as
businesses closed or downsized.
Stock Market Collapse: Global stock indices suffered
steep declines, wiping out trillions in investor wealth.
Banking System Collapse: Many major banks failed or
required government bailouts to survive.
Decline in Global Trade: International trade slowed as
economies contracted.
Housing Market Crash: Millions of homeowners
defaulted on mortgages, leading to foreclosures and
declining property values.
3.3 Government Response
Governments around the world took swift action to mitigate
the effects of the crisis and restore financial stability. Key
measures included:
TARP (Troubled Asset Relief Program): The U.S.
government injected $700 billion into failing banks and
financial institutions to prevent total collapse. This
program helped stabilize the banking sector and restore
confidence in financial markets.
Monetary Policy Adjustments: Central banks, including
the Federal Reserve and the European Central Bank,
aggressively cut interest rates to near-zero levels. This
was done to encourage borrowing, investment, and
economic recovery.
Quantitative Easing (QE): The Federal Reserve launched
multiple rounds of QE, purchasing government securities
and mortgage-backed assets to inject liquidity into the
financial system and lower long-term interest rates.
Stimulus Packages: Governments, including the U.S.,
China, and European nations, implemented large fiscal
stimulus programs. These packages funded
infrastructure projects, tax cuts, and direct financial aid
to boost demand and create jobs.
Dodd-Frank Act (2010): The U.S. government introduced
financial regulations to increase oversight, prevent risky
banking practices, and protect consumers. Key
provisions included restrictions on high-risk trading and
increased transparency requirements for financial
institutions.
International Coordination: The G20 Summit in 2009
played a crucial role in coordinating global economic
policies. Countries worked together to implement
stimulus measures, improve financial regulations, and
support economic recovery.
3.4 Case Study: Lehman Brothers Collapse
Introduction
Lehman Brothers, once the fourth-largest investment
bank in the United States, played a significant role in the
2007-2008 Financial Crisis. Its collapse marked the
largest bankruptcy in U.S. history and became a key
turning point in the global financial meltdown.
Background
Lehman Brothers had aggressively invested in mortgage-
backed securities and subprime loans, which were highly
profitable during the housing market boom. As housing
prices began to decline and mortgage defaults surged,
the firm faced mounting losses but continued to rely on
short-term borrowing to fund its operations.
Key Events
Early 2008: Lehman Brothers reported significant losses
as mortgage defaults increased.
September 10, 2008: The firm announced a $3.9 billion
quarterly loss, sparking investor panic.
September 12-14, 2008: Negotiations to save Lehman
failed after potential buyers, including Barclays and Bank
of America, withdrew due to lack of government
support.
September 15, 2008: Lehman Brothers filed for
bankruptcy with $619 billion in debt, the largest in U.S.
history.
Impact
Stock Market Decline: The Dow Jones fell 500 points on
the day of the bankruptcy, triggering a global financial
market crash.
Liquidity Crisis: Banks and financial institutions faced
severe liquidity shortages as interbank lending froze.
Economic Recession: The collapse intensified the
recession, leading to mass layoffs and further economic
decline worldwide.
Aftermath
The U.S. government introduced TARP (Troubled Asset
Relief Program) to bail out major banks and prevent
further collapses.
The Dodd-Frank Act (2010) was enacted to improve
financial regulations and reduce systemic risk.
The crisis led to global financial reform, with increased
banking oversight and stricter capital requirements.
3.5 Case Study: Icelandic Banking Collapse
Introduction
The 2008 Financial Crisis had an especially severe impact
on Iceland, where the banking system grew rapidly in
the years leading up to the crisis. The collapse of its
three largest banks led to a financial catastrophe,
making Iceland one of the hardest-hit nations during the
crisis.
Background
Iceland’s banks had expanded aggressively, borrowing
heavily from international markets to fund investments.
By 2008, the total banking sector’s assets had grown to
nearly 10 times the country’s GDP, making it highly
vulnerable to external financial shocks.
Key Events
2001-2007: Icelandic banks expanded rapidly, relying on
foreign capital and risky investments.
Early 2008: Investors lost confidence in Iceland’s banks
due to concerns over excessive debt and unsustainable
growth.
October 6-8, 2008: The Icelandic government took
control of the country’s three largest banks: Landsbanki,
Glitnir, and Kaupthing, as they defaulted on $85 billion
in foreign debt.
October 2008: Iceland’s stock market plummeted by
over 90%, and the Icelandic krona lost significant value.
Impact
Bankruptcy of Major Banks: The failure of Iceland’s
three largest banks led to the loss of nearly all private
banking assets.
Currency Devaluation: The Icelandic krona depreciated
by over 50%, causing inflation to spike.
Recession and Job Losses: The economy contracted
sharply, with GDP falling by 10% in 2009, and
unemployment reaching record levels.
Government Response & Recovery
Bank Nationalization: The government restructured the
banking sector by separating domestic and foreign
operations.
IMF Assistance: Iceland sought an IMF bailout of $2.1
billion to stabilize its economy.
Capital Controls: To prevent further currency
devaluation, strict capital controls were imposed.
Debt Restructuring: Policies were introduced to ease the
burden on homeowners and businesses, leading to a
gradual economic recovery.
Conclusion
Despite the initial economic devastation, Iceland’s
recovery strategy, including strong government
intervention and financial restructuring, allowed the
country to rebound faster than many other nations
affected by the crisis. The case of Iceland highlights the
risks of unchecked banking expansion and the
importance of proactive economic management in times
of financial instability.
3.1 Causes of the Crisis
The 2007-2008 Financial Crisis resulted from a
combination of financial mismanagement, risky banking
practices, and policy failures. The key causes include:
The Housing Bubble and Subprime Mortgages: During
the early 2000s, banks aggressively issued subprime
mortgages—loans to borrowers with poor credit
histories. As housing prices skyrocketed, financial
institutions assumed these borrowers would be able to
refinance their loans. However, when home prices
started declining in 2006, mortgage defaults surged,
causing severe financial losses.
Securitization and Risky Derivatives: Banks and financial
institutions bundled risky subprime loans into complex
financial products called mortgage-backed securities
(MBS) and collateralized debt obligations (CDOs). These
instruments were sold to investors worldwide, spreading
the risk across global markets.
Failure of Credit Rating Agencies: Credit rating agencies
assigned high ratings to risky securities, misleading
investors into believing that these assets were safe. As
mortgage defaults rose, these securities rapidly lost
value, triggering financial panic.
Leverage and Excessive Risk-Taking: Many financial
institutions operated with high levels of debt (leverage),
using borrowed money to invest in risky assets. When
asset values declined, their losses were amplified,
leading to liquidity crises and insolvencies.
Regulatory Failures: The U.S. government and financial
regulators failed to recognize and mitigate the risks
associated with the housing boom and the rapid
expansion of financial derivatives. Deregulation of
financial markets allowed excessive speculation and
inadequate oversight of financial institutions.
The Collapse of Lehman Brothers: The bankruptcy of
Lehman Brothers in September 2008 sent shockwaves
through global markets, leading to a severe liquidity
crisis and deepening the financial panic.
Global Interconnection: Due to globalization, financial
institutions worldwide were interconnected, meaning
that the crisis quickly spread beyond the United States,
affecting European and Asian economies as well.
