What Happens After a Financial Crisis?

A financial crisis takes place when at least one financial asset loses value at a sudden or unexpected rate. Market crashes (both housing and financial) and bank runs are a few examples of what a financial crisis can look like. They tend to occur every few decades. As an investor, it's important to have a plan for when something like this happens. While you can't predict the future, you can be prepared to mitigate the effects when disaster strikes.

A Historic Example—2008

One of the largest financial crises in history was the global financial crisis of 2008. While everything came to a head during that year, the problems began to pile on to one another long before that. In 1977, the Community Reinvestment Act was passed, allowing those in low-income communities to acquire mortgages more easily. But, as time went on, regulations began to faulter, subprime loans were being given out with increased frequency, and banks started handing them off to investors as "mortgage-backed securities" despite the truth being slightly more complex. With many borrowers unable to pay back their loans, the housing market crashed. Then, during September of 2008, Fannie Mae and Freddie Mac were seized by the government as a result of the credit crisis caused by the mishandling of subprime loan lending, which caused fear that more damage was to come in the financial markets. A week later, Lehman Brothers, an established investment banking firm many called "too big to fail", went bankrupt. After this, US banks began failing left and right. By the end of the month, the Dow Jones dropped well over 700 points, the largest decline in history.

What started as the collapse of the US housing market turned into an international problem, as the economies of other countries began to falter as well. Since major banks in places all over the world (namely Europe) had investments in these mortgage backed securities, they began to suffer the consequences as well. Governments collapsed, GDPs shrank significantly, and unemployment rates reached record highs in many European countries. With how interconnected money is globally, it's no surprise that such a catastrophic event in the United States would impact other economies. The recession that followed the events leading to the crash was felt by many. Although the key points listed may only be a fraction of what put the 2008 financial crisis together, they were crucial to the inevitable crash itself.

So, how did we recover?

The Aftermath

The Fed did something unprecedented—lowered the interest rate to zero. By doing this, it created a situation that limited the risk of borrowing money, providing an opportunity for funds to continue to circulate despite the recession. Banks were bailed out, saving taxpayers from taking a larger hit, and as a result, the US treasury was able to turn a profit. If the government didn't offer this deal, many of the companies that were bailed out would have been left to fail, further increasing the already high unemployment rate. Meanwhile, several programs were created to help prevent homeowners from defaulting on their mortgages, though such programs were not as beneficial to individuals as the bailout was to the larger industries. President Obama signed a law that provided stimulus to the general public, but again, it did not create a result significant enough to make a large difference to consumers. To this day, there are individuals who were never able to recover from the 2008 recession. The Dodd-Frank Act put measures in place to prevent such a crisis from crippling the economy the same way again.

Since then, the US has seen a few smaller economic crises, along with the most recent, larger one in 2020 caused by the COVID-19 pandemic. Although this crash is still impacting certain aspects of life in 2023, strict rules for banks, alongside the fact that the health of both the economy and US consumers today is far better than it was in 2008, has so far allowed a smoother, less devastating recovery, even with warnings of a potential recession yet to come.

Future Financial Crises

A financial crisis in the future is not a question of if, but when. How can you protect your investments when a financial crisis is looming? It's always important to have a diversified portfolio, and this can be a great buffer against a market crash. Try not to take on more risk than you can handle, and always do your research before choosing an investment. No matter how you choose to invest, it's necessary to know all the risks that come with it and be prepared for a worst case scenario just in case, even if it's unlikely. Recessions are a part of life, and it's crucial to be ready for when the next one comes. By keeping your investments in good shape, you give yourself the tools to best protect your funds no matter what life throws at them.

Disclosure: Webull Financial LLC (member SIPC, FINRA) offers self-directed securities trading. All investments involve risk. Index Option Contract Fees, Regulatory Fees, Exchange Fees and other Fees may apply. More info: https://www.webull.com/disclosures