University of Arkansas System
Type of paper: Thesis/Dissertation Chapter
The 2007-2008 Financial Crisis
The 2007-2008 Financial Crisis
The 2007-2008 financial crisis is also referred to as the global financial meltdown of 2008 and is ranked as the worst financial crisis after the great depression. The crisis started in the United States of America before spreading to other continents. It caused enormous economic losses and threatened the total collapse of big banks both in America and abroad. To avert a larger economic crisis, many governments came up with bailout plans aimed at ensuring that banks and other crucial financial institution did not collapse. The crisis resulted in the prolonged 2008-2012 worldwide recession as the sovereign debt crisis in the European Union.
Cause of the 2007-2008 financial crisis
The first main cause of the 2007- 2008 financial crisis was the bursting of the housing sector in the United States that had peaked in 2005 and 2006. Due to this peak, there were high cases of defaults on adjustable and subprime mortgage rates. Consequently, banks began to provide more credit to would-be home owners resulting in higher housing prices (Fried, 63). The construction boom witnessed in the United States in the years preceding the crisis was attributed to the readily available credit in the country that was driven by huge inflows of foreign money after the Asian financial crisis of 1997 and the Russian debt crisis. The real estate bubble in the United States also resulted from the rising real estate standards and careless spending consumer spending. During this time, it was very easy for individuals to access different types of loans including auto, credit card and mortgage loans resulting in an unexpected debt load among American consumers. There was also a sharp increase in financial agreements known collateralized debt organizations and mortgage backed securities which obtain their value from housing prices and mortgage payments (Fried, 73). These types of monetary inventions made it possible for investors and institutions from all over the world to invest in the American housing sector. As the American housing prices went down, the main global financial institutions that had borrowed hugely to invest in the American housing market began to report huge losses.
The second cause of the 2007-2008 financial crisis was sublime lending by financial institutions. The boom in the American housing industry created a tense competition among the major mortgage lenders in the country. With time, the number of creditworthy borrowers dwindled and this made many of the lenders relaxed on underwriting standards extending credit to uncreditworthy borrowers (Fried, 93). The government sponsored enterprises also maintained low underwriting standards in the years preceding the crisis. As the market power moved towards originators from securitizers and as government sponsored enterprises faced stiff competition from private securitizers, the mortgage standards went down and risky loans increased.
The third factor that caused the 2007-2008 financial crisis was the presence of easy credit conditions. In the years preceding the 2007-2008 economic crises, the Federal Reserve reduced the federal fund rates to 1.0 % from the previous rate of 6.5 %. The was mainly aimed at fighting the perceived danger of deflation, the effects of the 2001 terrorist attacks in the united states and also to soften the effect of the fall of the dot-com bubble. This and other factors generated a high demand for financial assets therefore raising the prices of the same assets while reducing the interest rates (Fried, 73).
The other factor that caused the 2007-2007 financial crisis was predatory lending by some financial institutions. In this type of lending, borrowers were tricked or enticed into entering into risk secured loans for the wrong purposes. One major institution that used this method was the Countrywide Financial which advertised for home financing loans with low interest rates. These loans involved detailed contracts and were exchanged for more expensive products on the closing day. Although the advert would indicate that people would be charged an interest of 1%, they were actually charged an interest of 1.5%, and the borrower would be put under the adjustable rate mortgage (Fried, 36). This predatory lending resulted in negative amortization. When the home prices went down, homeowners who were under the adjustable rate mortgage did not have any motivation to honor their monthly installments because they had lost their home equity. Other causes of the crisis include over-leveraging, wrong pricing of risk and deregulation among others.
Impact of the 2007-2008 financial crisis
The 2007-2008 financial crisis had far reaching impact on the American economy and the global economy. To begin with, the crisis had a major impact on financial markets all over the world. In October 2007, the Dow Jones industrial average index stood at 14,000 points before entering a period of sustained decline. Secondly, the crisis also impacted the financial institutions in the United States and other countries. The first warning signal of the pending economic crisis was the decision by BNP Paribas to stop withdrawals from 3 hedge fund accounts. According to the figures released by the international monetary fund, the major banks in Europe and the United States collectively incurred losses of more than $1trillion from bad loans and toxic assets. These losses were projected to go higher if nothing was done to alleviate the crisis. The crisis caused the bankruptcy of more than 100 mortgage lenders in the United States alone (Fried, 67). As the crisis reached its peak in 2008, a number of the main institutions were disposed under duress or were taken over by the government. Some of these institutions include Fannie Mae, Citigroup, Lehman Brothers, Washington Mutual, Merrill Lynch and AIG among others. The crisis also caused a huge reduction in wealth and consumer consumption. Between 2007 and 2008, all Americans are estimated to have lost more that a quarter of their total net worth. Other than financial losses, the crisis also had a psychological impact on many people. Cases of suicide were reported in some countries as some people could not stand the pain of loosing their hard earned money and wealth in general.
Generally, the 2007-2008 financial crisis could have been avoided if the Federal Reserve had taken the right actions. In response to the crisis, the US government introduced new regulations aimed at addressing issues like increased regulation of the shadow banking system, consumer protection, bank financial cushions and increased authority of the Federal Reserve to wind-down crucial institutions and executive pay, among other regulations. In 2012, the US president proposed more regulations aimed at reducing the ability of banks and other financial institutions to be involved in proprietary trading. These additional regulations became to be known as the Vocker Rules, in appreciation of Paul Vocker who had been very vocal in supporting them.
The US government response to the crisis
As noted earlier, the 2007-2008 economic crisis had far-reaching effects on the American economy. According to the international monetary fund, drastic measures needed to be taken before the crisis escalated further. In response to the crisis, the federal government of the United States enacted the Emergency Economic Stabilization Act of 2008 which is also known as the US bailout plan. The plan gave the United States Secretary of Treasury authority to spend $700 billion to ease the effects of the crisis on the economy (Fried, 82). More specifically, the money would be spent in acquiring distressed companies and assets in the country especially securities backed by mortgages and to supply liquid cash to banks to ensure that depositors don’t lose their savings. All the funds that were initially meant for buying distressed assets were redirected and injected into banks and other financial institutions. Meanwhile, the treasury was considering the economic importance of purchasing the targeted assets. The Emergency Economic Stabilization Act of 2008 was not discriminative but included both local and foreign banks. The main rationale of enacting the economic bailout plan was to improve liquidity in the country and stabilize the economy (Fried, 52). The bailout plan was a comprehensive economic strategy aimed at addressing the effects of the crisis and also its root causes. After the bailout plan was implemented, the American economy began to recover gradually. Iconic American companies like General Motors that were on the blink of bankruptcy started registering profits. More and more companies started hiring people easing the existing high rates of unemployment. American consumers also started spending as the economy continued to register positive recovery.
Fried, Joseph. Who Really Drove the Economy into the Ditch? New York, NY: Algora Publishing, 2012. Print