Background of Financial Crisis

The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006.[10][11] Already-rising default rates on "subprime" and adjustable rate mortgages (ARM) began to increase quickly thereafter. As banks began to increasingly give out more loans to potential home owners, the housing price also began to rise. In the optimistic terms the banks would encourage the home owners to take on considerably high loans in the belief they would be able to pay it back more quickly overlooking the interest rates. Once the interest rates began to rise in mid 2007 the housing price started to drop significantly in 2006 leading into 2007. In many states like California refinancing became more difficult. As a result the number of foreclosed homes began to rise as well.
Share in GDP of U.S. financial sector since 1860[12]

Steadily decreasing interest rates backed by the U.S Federal Reserve from 1982 onward and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing construction boom and encouraging debt-financed consumption.[13] The combination of easy credit and money inflow contributed to the United States housing bubble. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load.[14][15] As part of the housing and credit booms, the number of financial agreements called mortgage-backed securities (MBS) and collateralized debt obligations (CDO), which derived their value from mortgage payments and housing prices, greatly increased. Such financial innovation enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined, major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses. Falling prices also resulted in homes worth less than the mortgage loan, providing a financial incentive to enter foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the U.S. continues to drain wealth from consumers and erodes the financial strength of banking institutions. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses are estimated in the trillions of U.S. dollars globally.[16]

While the housing and credit bubbles built, a series of factors caused the financial system to both expand and become increasingly fragile, a process called financialization. U. S. Government policy from the 1970s onward has emphasized deregulation to encourage business, which resulted in less oversight of activities and less disclosure of information about new activities undertaken by banks and other evolving financial institutions. Thus, policymakers did not immediately recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. Some experts believe these institutions had become as important as commercial (depository) banks in providing credit to the U.S. economy, but they were not subject to the same regulations.[17] These institutions, as well as certain regulated banks, had also assumed significant debt burdens while providing the loans described above and did not have a financial cushion sufficient to absorb large loan defaults or MBS losses.[18] These losses impacted the ability of financial institutions to lend, slowing economic activity. Concerns regarding the stability of key financial institutions drove central banks to provide funds to encourage lending and restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions and implemented economic stimulus programs, assuming significant additional financial commitments.