How Overvaluing Assets Causes Financial Crisis
Start writing a post
Finance Investing

Overvaluing Assets Is The Most Harmful Cause Of Financial Crisis

There are a number of causes behind financial crisis, and arguably the worst is the overvaluing of assets.

247
Overvaluing Assets Is The Most Harmful Cause Of Financial Crisis

Hundreds of years ago, financial crises were insulated. It was a problem that a country would face on its own. If one country plummeted, others would face little to no struggles in relation.

Today's economy has been globalized. Investment banks are global. Oil companies are global. Free trade is encouraged, and the exchange of goods and prices have high interconnectivity. As a result, a financial crisis in either the United States, China, or the United Kingdom can have a rippling effect on the rest of the world.

There are a variety of things that can cause a financial crisis. One of the most harmful is the overvaluing of assets. Overvaluing assets caused both The Great Depression and the 2008 Financial Crisis. What is overvaluing assets, and how does it really harm the economy?

The overvaluing of assets typically originates in the stock market. That's how it started both in 2008 and 1929. To better understand overvaluing assets, we can study the 2008 financial crisis.

Banks were engaging in risky lending practices in 2008 like sub-prime loans and mortgage-backed securities.

Subprime Lending: Typically banks don't lend to individuals with low credit or little collateral. In the '90s however, banks began to engage in this sort of lending. This made it easier for people, in general terms, to purchase homes. As a result, the demand for homes rose quickly.

Mortgage-backed Securities: Banks also started to trade mortgage-backed securities. These were essentially bundles of a hundred mortgages, packed together. These securities were categorized by risk and being sold and bought by different banks. But banks knew little to nothing about the ability of these borrowers to pay back their mortgages. Despite that, the securities were being traded.

Eventually, low credit borrowers began to default on the loans. The sub-prime loan business began to tank, recouping little to nothing on their loans. Even further, the mortgage-backed securities were valued significantly higher than what they were worth.

A simple example follows. Banks had originally believed they may get 70% of the borrowed money back. They reported such numbers as assets in their books. But since they didn't really know much about the mortgage-backed security they purchased, they were surprised to find out high rates of borrowers were defaulting. They were making pennies on the dollar. The public began to notice and as a result, lowered stock investments into these banks. The stock market began to decline, and financial institutions were losing tons of money.

In situations where banks are closing and need money, there are two options:

1) get a loan from another bank, or

2) get a loan from the Federal Reserve.

But banks were afraid to make loans to each other because they didn't know the real value of the banks who were borrowing. Would they be paid back or not? So loans from banks to save other banks declined. Interbank lending dried up.

This led to a credit crunch. Banks were afraid to loan to everyone. If you weren't a top of the shelf creditor, you weren't getting a loan from the banks in 2008. Because of this, saving increased and spending declined. Banks weren't making investments in firms or households. Capital decreased dramatically. Without a loan, how can a business buy all the new equipment they need? How can they finance some of their more costly processes? Businesses closed.

In the end, the decrease in capital led to lower levels of productivity, creating a vicious cycle of crisis.

There are a few things that can be done to fix it. In this situation, the Federal Reserve did its best to preserve financial institutions. They "bailed out" the banks. The economy took years to recover, even after the necessary measures were taken. This sort of financial crisis can be dangerous for an inept economy. But at times it can be difficult to avoid such situations. There is little that can be done to anticipate this sort of situation. Questionable bank practices are difficult to monitor, let alone their impact on the economy.

Report this Content
This article has not been reviewed by Odyssey HQ and solely reflects the ideas and opinions of the creator.
Adulting

Unlocking Lake People's Secrets: 15 Must-Knows!

There's no other place you'd rather be in the summer.

933159
Group of joyful friends sitting in a boat
Haley Harvey

The people that spend their summers at the lake are a unique group of people.

Whether you grew up going to the lake, have only recently started going, or have only been once or twice, you know it takes a certain kind of person to be a lake person. To the long-time lake people, the lake holds a special place in your heart, no matter how dirty the water may look.

Keep Reading...Show less
Student Life

Top 10 Reasons My School Rocks!

Why I Chose a Small School Over a Big University.

109311
man in black long sleeve shirt and black pants walking on white concrete pathway

I was asked so many times why I wanted to go to a small school when a big university is so much better. Don't get me wrong, I'm sure a big university is great but I absolutely love going to a small school. I know that I miss out on big sporting events and having people actually know where it is. I can't even count how many times I've been asked where it is and I know they won't know so I just say "somewhere in the middle of Wisconsin." But, I get to know most people at my school and I know my professors very well. Not to mention, being able to walk to the other side of campus in 5 minutes at a casual walking pace. I am so happy I made the decision to go to school where I did. I love my school and these are just a few reasons why.

Keep Reading...Show less
Lots of people sat on the cinema wearing 3D glasses
Pinterest

Ever wonder what your friend meant when they started babbling about you taking their stapler? Or how whenever you ask your friend for a favor they respond with "As You Wish?" Are you looking for new and creative ways to insult your friends?

Well, look no further. Here is a list of 70 of the most quotable movies of all time. Here you will find answers to your questions along with a multitude of other things such as; new insults for your friends, interesting characters, fantastic story lines, and of course quotes to log into your mind for future use.

Keep Reading...Show less
New Year Resolutions

It's 2024! You drank champagne, you wore funny glasses, and you watched the ball drop as you sang the night away with your best friends and family. What comes next you may ask? Sadly you will have to return to the real world full of work and school and paying bills. "Ah! But I have my New Year's Resolutions!"- you may say. But most of them are 100% complete cliches that you won't hold on to. Here is a list of those things you hear all around the world.

Keep Reading...Show less
Lifestyle

The Ultimate Birthday: Unveiling the Perfect Day to Celebrate!

Let's be real, the day your birthday falls on could really make or break it.

55037
​different color birthday candles on a cake
Blacksburg Children's Museum

You heard it here first: birthdays in college are some of the best days of your four years. For one day annually, you get to forget about your identity as a stressed, broke, and overworked student, and take the time to celebrate. You can throw your responsibilities for a day, use your one skip in that class you hate, receive kind cards and gifts from loved ones and just enjoy yourself.

Keep Reading...Show less

Subscribe to Our Newsletter

Facebook Comments