A financial crisis is a sudden, sharp decline in the value of a financial asset. This decline can occur because of a variety of reasons: market panics, the bursting of financial bubbles (such as the famous tulip mania bubble in the 17th century), and bank runs. Financial crises often involve a collapse of confidence, which in turn can reduce the willingness of investors to invest, households to spend, and businesses to borrow.
In the case of the 2007-09 global financial crisis, the trigger was the prospect of significant losses on residential mortgage loans to subprime borrowers. The subsequent collapse of demand for housing led to a rapid devaluation of bundled mortgage loans and related securities, including collateralized loan obligations (CLOs), resulting in liquidity crises for many banks. The devaluation of these assets exacerbated the overall crisis by making it difficult to sell them or even to find buyers.
Other underlying causes included the gradual removal of barriers to entry into the financial markets, especially through the repeal of the Glass-Steagall Act in 1999, and the proliferation of new forms of short-term wholesale funding (including commercial paper, repos, and contingent financing commitments). In addition, the Federal Reserve Board’s aggressive lowering of interest rates over the decade inflated credit markets, encouraging lending practices that proved unsustainable. The final blow came with the failure or near-failure of a number of financial institutions, including Lehman Brothers in September 2008. This event, along with the broader global economic slowdown, triggered a recession and prompted government intervention.
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