Causes of the 2008 Financial Crisis - Coursework Example

Economic Crisis of 2008 Name Institution Professor Course Date Introduction The 2008 financial crisis is termed as the worst economic disaster after the great depression that had occurred in 1929 (Temin 2010). The financial crisis in a way reshaped the world of investment, banking and finance. The financial crisis threatened and even made some large financial corporations to collapse and this was prevented in that the national governments bailed out the institutions but as a result there was a drop in the stock markets globally. In a great number of years, the housing market was also affected in a great way and this led to foreclosures, evictions as well as prolonged unemployment. As a matter of fact, the crisis played a crucial role in the collapse of key businesses. There was also a decline in consumer wealth and this was estimated to trillions of dollars and there was also a downturn mostly in the economic activities and this eventually lead to the great recession that took place between 2008 and 2012. This also contributed to the European sovereign debt crisis (William 2012). The historical perspectives of the previous decades that led to the financial crisis depicts that the global economy was not in any way stale as it had been suggested by a number of observers. With that, the crisis was not in any way expected and based on the fact that it had complex roots, it continued to puzzle the economists, the policy makers as well as other commentators as it continued to unraveled and sucked into the companies and banks and latter on to the economies all over the globe. The collapse of the economy had devastating consequences for the households and this resulted in high levels of unemployment in addition to surging poverty. Some of the countries were also affected greatly than others and this was mainly as a result of the differences in the initial conditions which includes aspects such as labor market, state of the economy, institutional framework and the fiscal space and the countries exposure to both the indirect and direct impact of the crisis through the trade and credit channels. Causes of 2008 financial crisis Subprime lending One of the major causes of the financial crisis was the subprime lending. In times of tough competition between various mortgage lenders for a greater market share and revenue as well as instances when the supply of the creditworthy borrowers seemed to be limited, the mortgage lenders in a way relaxed in terms of stipulating the standards and this led to the origination of mortgages that were risky and mostly for the less creditworthy borrowers (Simkovic 2013). In addition, to the easy credit conditions, the competitive pressures also contributed to an increase in the subprime lending and mostly in the years preceding the crisis. A good example of these banks are the investment banks and the Government Sponsored Enterprises (GSEs) played a crucial role in expanding lending and they relaxed their standards with the aim of catching up with the already established and private banks (Labaton 2008 and Duhigg 2008). Growth of the housing bubble Another major cause of the financial crisis was the growth of the housing bubble. In regard to housing, the price of a typical American house is said to have increased by about 124% between the years 1998 and 2006. The housing bubble mainly resulted in a great number of the homeowner being able to refinance their homes through the use of lower interest rates while some of them opted to finance their consumer spending in that they were provided with second mortgages which were secures as a result of price appreciation (Koller 2012). There was also collateralized debt obligation and this enabled a great number of the financial institutions to have the capability of obtaining investor funds and these funds were used to finance the subprime and forms of lending, this extended and at increased the housing bubble and this generated larger fees. As a result by September 2008, the housing prices in the US had declined by about 20% as compared to the mid 2006. With the decline in price, those borrowers who had adjustable rate mortgages were not in a position to refinance so as to avoid the higher payments that were mainly associated with the rising interest rates and as a result a great number of them defaulted on their mortgages. Easy credit conditions Another major cause of the economic crisis of 2008 was the easy credit conditions. It is believed and asserted that lower interest rates in a way encourage borrowing. Between 2000 and 2003 the Federal Reserve implemented measures that were aimed at lowering the federal funds rate and in relation to these the target was lowered from 6.5% to 1% (Federal Reserve Board n.d). This was done so as to soften the resulting effects if the dot-com bubble collapse, the terrorist attacks and also to tackle the perceived risks related to deflation. The excessive credit growth in a way contributed to the harshness of the crisis. The additional downward pressure that was inserted on the interest rates was as a result of the rising and high US currently account deficit which was said to have peaked alongside the housing bubble that occurred in 2006. Based on Ben Bernanke stated that trade deficits forced the US to borrow money abroad and this was to aid in the process of bidding up the bond prices and also in lowering the interest rates. According to him, the US current account deficit increased significantly to $650 billion between 1996 and 2004 and this meant a rise from 1.5% to 5.8% of the GDP. In light to these, the financing of the deficits required the US to borrow greatly from those countries that had trade surpluses and this included countries such as Asia and other nations that were importing oil. This meant that there was a flood of funds in the US financial markets. In respect to these, the foreign governments supplied the funds and they facilitated this through the purchasing of the treasury bonds and this played an essential role in avoiding the direct effects associated with the crisis. A great number of the US households made use of the borrowed funds and financed their consumption while other chooses to bid up the prices of financial assets and financing. The Fed increased their rates between 2004 and 2006 this led to an increase in one year and five year adjustable rate mortgage rates (ARM) this made the ARM interest rate resets to be more expensive for the homeowners. This is seen as a major contributing factor to the deflating of the housing bubble since the asset prices tends to move inversely to the interest rates and this making it riskier to speculate aspects related to housing (Max 2004). Weak and fraudulent underwriting practices Based on the information by the financial crisis inquiry commissions on the events that occurred during the tenure of Richard M. Bowen suggested that when the US Housing Bubble was in its final years, there was evidence of the collapse of the mortgage underwriting standards. Based on him by 2006, about 605 of the mortgages that had been purchased by Citi were defective this meant that they were not underwritten to policy while some failed to contain all the policy required documents. Moreover as of 2007, the defective mortgages increased greatly (Morgenson 2010). Additionally, the officers of Clayton Holdings which was by then the largest and greatest residential loan company revealed that there review of about 900,000 mortgages which had been issued between January 2006 and June 2007 showed that scarcely 54% of the loans had met the originators underwriting standard. The analysis further showed that 28% of the loans that had been sampled failed to meet the minimal standards of the issuers. Evidence shows that the GSEs were more effective when it came to policy underwriting by the originators and they were also good at forcing the underwriters to make a repurchase of the defective loans. This was contrary to the private securitizes since they were less aggressive and also less effective when it came to recovering losses from the originators and mostly when borrowing on behalf of the investors (Simkovic 2013). Predatory lending This was also seen as being among the major causes of the 2007 financial crisis. Predatory lending is termed as the practice of borrowers being enticed into unsound and unsafe secure loans aimed at funding inappropriate purposes and this is mainly done by the unscrupulous lenders (Hawke 2000). A good example of such lenders at the Countrywide Financial in that they advertised for low interest rates in regard to home refinancing. The loans were mainly written in detailed contracts and later swapped into more expensive loan products at the end of the day. while the advertisements stated that an interest 1% or 1.5% were to be chargers, the consumers were also put into an ARM and this meant that the interest charged at times was greater when compared to the interest paid. This lead to negative amortization and in most instances the credit consumers failed to notice it after the loan had been facilitated. Another company that engaged in such practices is Ameriquest and stated that they were forced to falsify mortgage documents and them sold the mortgages to the wall Streets banks in a bid to make fast profits. The available evidence shows that such mortgage frauds were seen as the major causes or contributing factors to the crisis. Overleveraging or increased debt burden Before the financial crisis, the financial institutions became highly leveraged in that they increased their appetite for the risky investments and at the same time reduce their resilience in case of the losses. A great amount of these leverage was mainly achieve through the use of complex financial instruments, for example, the off-balance sheet securization as well as derivative and this made it difficult for the regulators and creditors to monitor or they to reduce the risk levels of the financial institutions. The instruments may make it impossible for the reorganization of the financial institutions failing into bankruptcy and this in a way contributed to the need of government bailout. The financial institutions and the US households were increasingly indebted in the years preceding the crisis. This in a way increased their vulnerability due to the collapse of the housing bubble and this also worsened the ensued economic downturn (The Federal Reserve Bank of San Francisco 2009). Financial complexity and innovation Financial innovation is termed as the ongoing development of the financial producers that are mainly designed as to attain certain client objectives, for example, the offsetting of risk exposure such as default y a borrower or assist in the obtaining of the financing. Some good example of the financial innovation products included the ARM, collateralized debt obligations (CDO), mortgage backed securities (MBS) and credit default swaps (CDS). There was wide usage of the products in the years prior to the crisis. The usage of such products varied in complexity as well as in the ease in which they were valued on the books of the various financial institutions. The new financial products went hand in hand with greater levels of complexity and it also multiplied the actors that were involved in a mortgage. This the increased distance the actors had no option but to rely on indirect information and this augmented the risks and offered ground for misjudgments, fraudulent acts as well as to the collapse of the market (The Financial Inquiry Commission n.d ). Incorrect pricing of the risks The incorrect pricing of risks was seen as being another major cause of the crisis. Pricing of risks is termed as incremental compensation that is required by the investors in a bid to take on additional risk and at times it may be measured in terms of interest rates or in relation to fees. There was a lack of transparency in relation to the bank risk exposures and this prevented the markets from pricing the risks in the correct manner before the occurrence of the crisis. This in turn enabled the mortgage markets to grow than it would have in normal circumstances and it also made the crisis more disruptive than it would have been. It is also believed that if the risk levels had been disclosed earlier the risks would have been priced correctly. Due to a number of reasons, the participants in the market failed to accurately measure the risks that were inherent with the financial innovations and they also failed in understanding the effects that the new financial innovations would have on the financial system stability (The White House 2008). Commodities boom After the collapse o the housing bubble there was a rapid increase in the number of commodity prices. For instance the price of oil was almost triple in that it moved from a cost of $50 to $147 from early 2006 to 2008 prior to dropping as the financial crisis took hold in the late 2008. Experts in the field debate this as a major cause of the financial crisis. Some experts attributed the financial crisis but the speculative flow of money from housing as well as to other forms of investment into other commodities. Others attribute it to the increase of scarcity of raw materials thus leading to long position being held in such markets. The increase in oil prices diverted the consumer spending into gasoline and this created a downward pressure in relation to the economic growth of those countries that majored on oil importation (Pezzuto 2013). Conclusion Based on the above discussion, it is clear that the 2008 financial crisis was the worst economic disaster after the great depression that had occurred in 1929. The financial crisis in a way reshaped the world of investment banking and finance. the financial crisis was a result of a number of factors and this includes subprime lending, growth of the housing bubble, boom in commodities, incorrect pricing of the risks, Financial complexity and innovation, Overleveraging or increased debt burden, easy credit conditions, predatory lending and Weak and fraudulent underwriting practices . It is crucial to note that a greater number of people believe that the crisis would have been averted if the right measures would have been put in place in the right time. References Dihigg, C 2008, ‘Pressured to Take More Risk, Fannie Reached Tipping Point’, The New York Times, 4 Oct, viewed 23 August 2016, http://www.nytimes.com/2008/10/05/business/05fannie.html Hawke, J 2000, ‘Letter from the Comptroller of the Currency Regarding Predatory Lending"’, viewed 23 August 2016, http://www.banking.senate.gov/docs/reports/predlend/occ.htm Koller, C 2012, White Collar Crime in Housing: Mortgage Fraud in the United States, LFB Scholarly, El Paso, TX. Labaton, S 2008, ‘Agency’s ’04 Rule Let Banks Pile up New Debt’, The New York Times, 2 Oct, viewed 23 August 2016, http://www.nytimes.com/2008/10/03/business/03sec.html?_r=0 Max, S 2004, ‘The Bubble Question’, CNN, July, Viewed 23 August 2016, http://money.cnn.com/2004/07/13/real_estate/buying_selling/risingrates/ Morgenson, G 2010, ‘Raters Ignored Proof of Unsafe Loans, Panel is told’, The New York Times, 26 September, viewed 23 August 2016, http://www.nytimes.com/2010/09/27/business/27ratings.html?_r=2&pagewanted=all Pezzuto, I 2013, Predictable and Avoidable: Repairing Economic Dislocation and Preventing the Recurrence of Crisis, Gower Publishers. Simkovic, M 2013, ‘Competition and Crisis in Mortgage Securitization’, Indiana Law Journal vol. 88, p. 213. Temin, P 2010, The Great Recession and the Great Depression, National Bureau of Economic Research. The Federal Reserve Bank of San Francisco 2009, ‘A Minsky Meltdown: Lessons for Central Bankers’, viewed 23 August 2016, http://www.frbsf.org/our-district/press/presidents-speeches/yellen-speeches/2009/april/yellen-minsky-meltdown-central-bankers/ The Federal Reserve board n.d, ‘Open Market Operations’, viewed 23 August 2016, http://www.federalreserve.gov/monetarypolicy/openmarket.htm The financial Crisis Inquiry Commission n.d, ‘The Story of a Mortgage Security: Inside CMLTI 2006-NC2’, viewed 23 August 2016, http://fcic.law.stanford.edu/resource/staff-data-projects/story-of-a-security The White House 2008, ‘Declaration of the Summit on Financial Markets and the World Economy’, viewed 23 August 2016, http://georgewbush-whitehouse.archives.gov/news/releases/2008/11/20081115-1.html William, C 2012, ‘Euro crisis imperils recovering global economy, OECD warns’, Los Angeles Times, May 22, Viewed 23 August 2016, http://latimesblogs.latimes.com/world_now/2012/05/eurozone-crisis-global-economy.html Read More