Because of the numerous causes of this event, the U.S. recession and subsequent global financial crisis that began in 2007 has generated a great deal of academic and political interest in understanding its nature and how its repetition may be avoided in the future. This paper will cast a light on the roots of the 2007-2010 global financial crisis, its impacts and the tools employed to bring it to a close.
Keywords: Community Reinvestment Act (CRA); Federal Reserve Bank (Fed); Global Economics; Housing Bubble; Recession; Subprime Mortgage; Troubled Asset Relief Program (TARP)
Adherents to the familiar George Santayana axiom, "Those who ignore history are condemned to repeat it," would find validation in the history of recessions in the United States. One of the worst recessions in U.S. history took place when a land speculation bubble (an uncorrelated increase in prices) began to rapidly collapse upon itself. Banks, fearful of insolvency, suspended certain transactions, sending the economy into a severe recession that lasted for a year. This recession was at the time the worst recession the United States had ever experienced. More importantly, it was one of the first recessions in U.S. history, commencing in 1797, less than 10 years after the Constitution was ratified.
The "Panic of 1797," as it was known, would be succeeded by dozens of recessions over the course of the following two centuries. This list includes what most historians deem the worst recession in U.S. history: the Great Depression of the 1930's. The first decade of the 21st century began with a severe recession, exacerbated by the horrific terrorist attacks on the World Trade Center and the Pentagon in 2001. Only a few years after that recession came to an end and the economy grew again, another recession began. This period, which began in 2007, resembled the Panic of 1797 in many ways, although its severity and global impact most commonly drew comparisons to the Great Depression.
There are those who believe that the global recession of 2007-2008 and the subsequent two-year crisis it created came unexpectedly, while others claim to have seen the warning signs more than a year before it began. Because of the numerous causes of this event, the recession of global financial crisis that began in 2007 has generated a great deal of academic and political interest in understanding its nature and how its repetition may be avoided in the future. This paper will cast a light on the roots of the 2007-2010 global financial crisis, its impacts and the tools employed to bring it to a close.
The Housing Bubble
Similar to the Panic of 1797, the roots of the global financial crisis of 2007-2010 can be found in real estate. After the United States began reemerging from the 2001-2004 recession, housing prices began to show unusual upward mobility. Political leaders and other observers, however, were clouded by the apparent good news surrounding home ownership — more homes purchased meant more jobs and more consumer spending. Then again, the rise in housing prices could not be correlated to any other area of growth. In fact, many economists argued that what was occurring was not a sign of economic growth but a housing bubble (an unexpected and temporary inflation in housing prices) that was doomed to burst and contract. In 2005, that possibility became reality, as a number of key markets saw housing prices decline. Then-Chairman of the Federal Reserve Bank (the Fed) Alan Greenspan acknowledged that the market, in some areas, was becoming "frothy," but said that a housing bubble was unlikely (Freeman, 2005).
By 2006, Chairman Greenspan's comments were largely discredited. In fact, many began to turn on the Fed, suggesting that that institution's recommendation that interest rates stay at record low levels (a policy that began in the late 1990s) started a housing boom. Home purchases were promoted by the government as contributors to individual wealth and retirement plans. The Fed even made mortgage interest rates tax-deductible, another incentive for homeowners to buy homes and make renovations thereto (Kohn & Bryant, 2010). Home ownership increased with the government's message to Americans that the more real estate they owned, the greater their wealth would be.
The Community Reinvestment Act
The increased number of home purchases that occurred was also attributable to another trend. Lending institutions had begun to sell subprime mortgages to a growing number of homeowners. Subprime mortgages are housing loans that are offered to people with low incomes and/or poor credit. Subprime mortgages have been in existence since the 1990s, although the government strongly encouraged banks to provide affordable loans to low-income and debt-ridden residents since the 1970s, when the government passed the Community Reinvestment Act (CRA) to prevent discrimination among mortgage programs (Brook, 2008). The CRA gave rise to the government's push for lending institutions to have available mortgages that the poor could afford. Subprime lending was ardently backed by the government, including the mortgage security giants Fannie Mae and Freddie Mac. Still, in light of the fact that subprime lending involves providing individual loans of hundreds of thousands of dollars to people already saddled with debt and/or poor credit, there is an obvious risk attached to the practice. Still, the government, Fannie Mae and Freddie Mac forged ahead with the pro-subprime lending campaign (Brook, 2008).
Because the government was actively promoting subprime lending (and apparently looking the other way on predatory lending), lending institutions became focused on securing high volumes of such mortgages. Major financial institutions, like AIG and Merrill Lynch, worked diligently to compete for this business by acquiring smaller lenders with reputations for subprime lending (Dickey, 2010). These lenders were paid not based on the quality of the mortgages but by volume, and major institutions took account of this volume and the profits it yielded. Indeed, subprime lending presented great potential returns in the short term.
By 2007, it became clear that the risks associated with subprime mortgages were very real. A stagnant economy meant more people were making less and starting to realize that they were unable to meet their financial commitments. The Fed, which is supposed to protect banks through regulation, went instead with the tide, supporting the subprime industry and the dangers they represented. In fact, the Fed did not require financial institutions to set aside the adequate amount of money to offset potential losses — this regulatory requirement was woefully outdated (Appelbaum & Cho, 2009). Meanwhile, the Fed signed off on acquisitions of subprime lenders made by Citigroup and Wachovia, two major financial institutions with global connections. Banks also sought to offset the risks by selling high-risk loans in pools on the markets. Over time, banks began to realize that the housing market was becoming sour, and their losses were starting to pile up.
The Crisis Goes Global
The overwhelming losses affecting U.S.-based financial institutions sent shockwaves around the world. Financial giant Lehman Brothers went bankrupt in September of 2008 and AIG teetered on the brink as well. High-risk mortgages were folded into other pension, mutual, money market and other funds in order to mitigate those dangers. Investors from all over the world were unwittingly made participants in the subprime industry; when the risks came to fruition, investors worldwide experienced losses. In fact, because few understood that the subprime lending industry was so vast and integrated into the securitized market, some investors actually invested more of their money than they had through leveraging; their faith in the marketplace was based on ignorance of the presence of toxic subprime mortgages.
The growing global crisis was exacerbated by the fact that, in the midst of the collapse of Wall Street's biggest figures, short-term lending and capital was nearly halved. New loans to large borrowers fell by 47 percent in the last quarter of 2008 compared to the previous quarter. Lending actually sloughed by 79 percent compared to the height of the "credit boom," which had peaked in 2007 (Ivashina & Scharfstein, 2010). Banks, particularly those that were dependent on credit rather than deposit accounts, were becoming less likely to lend to expanding businesses. On the global stage, monetary policy was extremely loose. Monetary policy that was used in the U.S. to boost consumption after the "dot com" bubble burst during the early 21st century, led to a large number of trade imbalances with emerging market economies like...
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