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Business Economics · Recent macroeconomic history

The 2007-08 Global Financial Crisis: Causes, Transmission and Outcome

Updated 11 October 2026 · Fact-checked

The 2007-08 Global Financial Crisis began with falling US house prices and defaults on subprime mortgages. Losses on securitised assets hit highly leveraged banks, trust froze, and credit dried up. Lehman's failure in September 2008 spread panic worldwide. Trade, output and jobs fell sharply, producing the Great Recession. Answer by linking cause, transmission and outcome.

Understand The 2007-08 Global Financial Crisis

Start with the cause. In the years before 2007, interest rates in the US were low and credit was easy. Banks lent to subprime borrowers, who had weak credit records, often with little checking of income. Lenders could do this because they did not keep the loans. They sold them on.

That is securitisation. Mortgages were pooled and turned into securities such as mortgage-backed securities and collateralised debt obligations. Rating agencies gave many of these high ratings. Investors around the world bought them, believing they were safe. Banks also held them, often funded by short-term borrowing and with high leverage. Incentives were poor: the people who made the loans bore little of the risk, which is a moral hazard and information asymmetry problem.

Then house prices stopped rising and began to fall in 2006-07. Borrowers defaulted, especially on loans whose low initial rates had reset higher. Securities lost value, and nobody knew which banks held the losses. Banks stopped lending to each other, so the interbank market froze. Banks relying on short-term funding faced a liquidity crisis, which then turned into a solvency worry.

The crisis peaked in September 2008. Lehman Brothers, a large US investment bank, failed and was not rescued. This showed how systemic risk works: the failure of one institution damages others through linked contracts, falling asset prices and loss of confidence. Governments and central banks then rescued banks, cut interest rates sharply and later used quantitative easing and fiscal stimulus.

The crisis spread globally through bank holdings of US securities, funding markets, falling trade and lower confidence. Credit shrank, firms cut investment, households cut spending and unemployment rose. Many economies fell into the Great Recession. Emerging markets, including India, saw capital outflows, a weaker rupee and slower growth, though their banks were less exposed.

Key rules to remember

Leverage ratio
Leverage = Total assets ÷ Equity
Higher leverage means a small fall in asset value can wipe out equity. For example, leverage of 30 means a fall of about 3.3% in assets erases equity.
Equity wipe-out point
Fall in assets that eliminates equity = 1 ÷ Leverage
Use it to show why highly geared banks were fragile.
Causal chain
Easy credit → subprime lending → securitisation → house price fall → defaults → asset losses → credit freeze → recession
A structure for any essay. Add the Lehman event and policy response.

How to solve The 2007-08 Global Financial Crisis questions

Most questions ask you to explain causes, transmission or consequences. Use one fixed structure so you do not miss a link.

  1. 1Read the command word: explain, discuss, evaluate or calculate.
  2. 2Define key terms in one line each: subprime, securitisation, leverage, systemic risk.
  3. 3Set out the causes: low rates, lax lending, securitisation, weak ratings, high leverage, poor regulation.
  4. 4Explain the trigger: falling house prices, defaults and losses on securities.
  5. 5Show transmission: interbank freeze, liquidity then solvency problems, Lehman, global links.
  6. 6Describe the outcome: credit crunch, falling output and trade, unemployment, the Great Recession.
  7. 7Add the policy response: rate cuts, bank rescues, quantitative easing, fiscal stimulus, tighter regulation.
  8. 8Give a short conclusion that names the main cause and the main lesson.

Quickest way: Cause, trigger, spread, outcome

When to use it: Use for MCQs and for short written answers when time is tight.

  1. Write four labels: Cause, Trigger, Spread, Outcome.
  2. Cause: easy credit, subprime loans, securitisation, high leverage.
  3. Trigger: US house prices fall, defaults rise.
  4. Spread: frozen interbank lending, Lehman failure, global bank holdings.
  5. Outcome: credit crunch and Great Recession, then policy response.
  6. For calculations, use 1 ÷ leverage for the equity wipe-out.

Common mistakes in The 2007-08 Global Financial Crisis

  • Saying subprime mortgages alone caused the crisis.

    The name 'subprime crisis' makes it sound like a single cause.

    Fix: Treat subprime defaults as the trigger. Add securitisation, leverage, weak ratings and poor regulation as the reasons losses became systemic.

  • Confusing liquidity with solvency.

    Both appear as banks 'running out of money'.

    Fix: Liquidity means unable to meet short-term payments. Solvency means liabilities exceed assets. Frozen funding markets created the first, and asset losses threatened the second.

  • Describing securitisation without saying why it spread risk.

    Students memorise the definition but not the effect.

    Fix: Explain that pooling and selling loans moved risk across the system, weakened lender incentives, and hid who held the losses.

  • Treating Lehman's failure as the only cause.

    It is the most famous event.

    Fix: Present it as the moment confidence collapsed. The weaknesses existed earlier, and the crisis had already begun in 2007.

  • Ignoring the global transmission channels.

    Students stop at the US housing market.

    Fix: Name at least two channels: bank exposure to US securities, funding market freeze, falling trade and lost confidence.

  • Listing policy responses without linking them to the problem.

    Students recall the list but not the purpose.

    Fix: Pair each response with its aim: rate cuts and liquidity support for funding stress, bank rescues for solvency, stimulus for falling demand.

Worked examples

Example 1

A bank has total assets of ₹2,000 crore and equity of ₹80 crore. (a) Calculate its leverage. (b) By what percentage must asset values fall to wipe out its equity? (c) Explain why this matters in a crisis.

Show the solution
  1. (a) Leverage = Total assets ÷ Equity = 2,000 ÷ 80 = 25.
  2. (b) Fall that eliminates equity = 1 ÷ 25 = 0.04, which is 4%.
  3. Check: 4% of ₹2,000 crore = ₹80 crore, equal to equity.
  4. (c) A small fall in asset prices, such as from mortgage-linked losses, can make the bank insolvent. Highly leveraged banks therefore become fragile, and doubts about them spread fear to other institutions.

Answer: Leverage is 25. A 4% fall in asset values wipes out equity. High leverage made banks vulnerable to modest losses and added to systemic risk.

Example 2

Explain how the failure of Lehman Brothers in 2008 illustrated systemic risk and helped turn a US housing problem into a global recession.

Show the solution
  1. Define systemic risk: the risk that one institution's failure damages many others and the whole system.
  2. Link to cause: Lehman held large exposure to mortgage-related assets funded by short-term borrowing and high leverage.
  3. Describe the event: it failed in September 2008 and was not rescued, which shocked markets.
  4. Explain contagion: other firms were its counterparties, so they faced losses. Asset prices fell further, and lenders feared any bank might be next.
  5. Describe the effect: interbank and credit markets froze, so firms and households could not borrow easily.
  6. Link to real economy: investment, spending and trade fell, unemployment rose and many countries entered recession.
  7. Add response: governments and central banks supported banks, cut rates and used stimulus to restore confidence.

Answer: Lehman's failure showed that interlinked, leveraged institutions can transmit losses and panic. The resulting credit freeze cut spending and trade worldwide, deepening the Great Recession.

Exam tips

  • Learn the chain of events in order. Examiners reward a clear sequence of cause, trigger, transmission and outcome.
  • Define subprime, securitisation, leverage and systemic risk precisely. Use them in your answer.
  • In longer questions, include both the US causes and the global channels. Mention India or emerging markets if asked about transmission.
  • For MCQs, watch for options that confuse the trigger with the underlying causes, or liquidity with solvency.
  • Do not state exact figures from memory unless you are sure of them. Clear reasoning earns more than uncertain numbers.

Practice questions from Recent macroeconomic history

The 2007-08 Global Financial Crisis in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

The 2007-08 Global Financial Crisis: frequently asked questions

What caused the 2008 global financial crisis?

Easy credit and lax lending produced many subprime mortgages. These were securitised and sold widely, while banks used high leverage. When US house prices fell, defaults rose and losses spread through the financial system.

How did subprime mortgages cause the crisis?

Subprime borrowers defaulted when house prices fell and loan rates reset higher. The loans sat inside securities held by banks and investors worldwide. Losses were large and hard to locate, so trust collapsed.

Why did Lehman Brothers' collapse matter so much?

It was a large, interconnected firm, and its failure showed that rescue was not guaranteed. Counterparties faced losses and lenders stopped trusting each other. This is a clear example of systemic risk.

What was the Great Recession?

It was the deep global downturn that followed the crisis. Credit tightened, trade and output fell and unemployment rose in many countries. Governments responded with lower interest rates, bank support and stimulus.