Cause and Effects of the Financial Crisis

Abstract 

The 2008 financial crisis begun in a singular sector within the US economy. This is the mortgage sector, which is a subsector within the larger banking and allied sector. However, the impact of the crisis severely and adversely affected the entire sector, US economy, government, and populace. It also led to an economic recession that lasted until 2012. In this research paper, an evaluation is made on the causes and effects of the financial crisis and what has been done to ensure it does not happen again. It is clear from the research and analysis that having a free economy did not cause the crisis but rather those who took advantage of it. Any step taken to prevent a recurrence that also infringes on economic freedom is thus counterproductive. 

Introduction 

When the Lehman Brothers Investment Bank collapsed on the 15 th day of September 2008, this was considered to be the worst possible nightmare for the US economy, yet it proved to be just the beginning. Several banks and institutions considered as too large to fail continued to collapse creating one of the greatest financial crisis in modern history. Due to globalization, although the crisis was purely an American issue, its impact spread across the world with Europe being the worst hit. Extensive investigation has since been undertaken by different organizations to establish the cause of the crisis and how to avert its recurrence in future. Different organizations and groups have come up with different explanations for the cause, with some taking the semblance of a blame game (Gorton, Metrick & Xie, 2015) . Based on respective sets of causation, several steps have been taken by the different organizations and stakeholders to ensure that such a crisis does not occur in the future. Unfortunately, some of the steps undertaken to prevent the future occurrence of such a crisis seem punitive and have had the effect of placing an inordinate disadvantage on US corporations in the global marketplace (Lins, Servaes & Tamayo, 2017) . As this research paper will reveal, the financial crisis was caused by a conjunction of difference factors coupled with laxity, lethargy or indifference from government and private sector regulators; with its effects being detrimental to all stakeholders. 

Background Information 

Even today, some investors still insist on keeping their reserves in investments that have an actual rather than virtual value. These investments include gold, precious stones, art, and artifacts or even real estate. These items are as secure as the traditional economy was under barter trade where the value of each item was real and not imagined. The advent of a monitory economy came with the aspect of imagined value being agreed upon and based on almost worthless pieces of paper (Thakor, 2015) . A signed check, for example, could be worth a ton of gold. However, if the person who signed the check loses the authority that came with the signature, the check will only retain its value in paper and ink. This scenario defines what happened during the 2008 financial crisis. The real value of land and buildings were put in the form of mortgages that were taken by Americans who wanted to own homes. 

Federal government organs such as Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC) played a positive role in assisting these Americans to own homes (Gorton, Metrick & Xie, 2015) . The mortgages themselves were also given a value to enable the financial institutions to use them as a means to make more money. Based on the example above, the ton of gold was represented in the signed check. The value of the signed check was then gradually augmented until it became the value of ten tons of gold owned by ten different people. Eventually, the ten people realized that there was only one ton of gold thus, demanding to cash their respective checks. Realizing the precarious situation, the signatory of the check admitted to the error leading to a market crash and a financial crisis. 

Causes of the Crisis 

The Increasingly Free US Market 

Compared to many world nations, the USA is one of the youngest economies in the world having come into being about three centuries ago. W ithin its first century of existence, the US economy had grown into one of the greatest economies in the world. One of the bearing factors to this acute growth was a free market mainly controlled by the market dynamics of demand and supply. In the early 20 th century, the great depression led to the creation of several government checks and balances over the market and by extension the economy. As the economy kept growing, however, the horrors of the great depression were forgotten, and one by one the control measures were removed (Treeck, 2014) . Eventually, in 1999 the last control measure over financial institutions was removed when the Glass–Steagall legislation was repealed . Having a free market, dominated by financing using virtual money is one of the leading cause of the 2008 financial crisis (Gorton, Metrick & Xie, 2015) . This was because no one had active oversight over the market. 

The U.S. Housing Bubble and Foreclosures 

Being a homeowner is part of the great American Dream, but has been unavailable for many working Americans. Towards the end of the 20 th century, government programs such as Fannie Mae and Freddie Mac alongside private sector programs sought to make this American Dream a reality. Millions of Americans were assisted in getting homes through mortgages. The availability of mortgages led to an increased demand for housing. Under the laws of demand and supply, this immediately led to the increase in the prices and value of homes in the USA (Thakor, 2015) . Between 1997 and 2005, the value of homes had more than doubled as reflected in the graph below. A mortgage worth a million dollars in the year 1997 would, therefore, be worth about two million dollars in 2005. Therefore, the owner of the homeowner had an opportunity to get more financing using the same home as collateral up to the same value of the home. At the same time, the financier was now holding a security that was double the value that had been loaned out to the homeowner and could use the higher value to trade with other financiers. An artificial financing boom was thus created as the value of housing increased (Treeck, 2014) . The value of the mortgages as trading tools between different financing institutions also grew. Even organizations that erstwhile did not deal with mortgages such as insurance companies noticed that fortuned were being made in the industry and joined in. 

In 2005, the artificially high cost of homes suddenly begun to plummet and gradually the reality that organizations may have been trading on artificial value began to sink in. The financing had become so entangled that many debtors were also creditors to their creditors and vice versa while insurance companies also owned the financial instruments that they had insured. Trying to disentangle this mess eventually led to the collapse of banks thought to be too large to fail hence causing a panic, which precipitated the 2008 financial crisis. 

Main Actors in the Financial Crisis 

The Federal Reserve 

The Federal Reserve must play the role of the regulator in the US economy. Indeed, the Federal Reserve exists to ensure that eventualities such as the 2008 financial crisis do not happen. For matters to get out of hand until major financial institutions begin to collapse, the Federal Reserve must have abdicated on its duties. The Federal Reserve members could not have failed to notice that greed and carelessness had led to what can only be defined as toxic mortgages. These are mortgages whose value had been multiplied so many times because it had repeatedly been traded by different entities. The Federal Reserve thus, failed in taking steps to stem the development of, and trade in toxic mortgages (Thakor, 2015) . 

The Bush Presidency 

The development of the financial crisis that was to lead to 2008 crisis happened during the pendency of the Bush presidency and two wars, both of which are bearing factors to the crisis. The Bush administration was not only Republican but also led by a president from Texas, the capitalist capital state in the USA. The policy of governmental non-interference on commerce was, therefore, at the center of the Bush presidential policy (Thakor, 2015) . The government declined to intervene in the crisis as it gradually developed between 2005 and 2008 where intervention would have had the greatest positive impact. Further, the government was involved in two extremely unpopular wars and may have shied away from seeming to antagonize big corporations. By trying to do the right thing in allowing markets to control themselves without governmental interference, the Bush Administration allowed the financial crisis both to happen and also to escalate. 

Commercial Banks and Mortgage Backed Security Investors 

Commercial Banks and Mortgage Backed Security Investors are the main culprits for the 2008 financial crisis as it is their conduct that led directly to the crisis. It is commercial banks that allowed for the refinancing of mortgages based on the new values of homes without assessing whether the paper value of the homes matched their actual value. It is also the commercial banks that roped in Mortgage Backed Security Investors to make greater profits by taking advantage of the real estate boom (Lins, Servaes & Tamayo, 2017) . Banks and investors failed to realize that the absence of governmental superintendence in their activities placed an onus upon them for self-regulation. Instead, they acted with abandon and recklessness, made fortunes then lost them all at once leading to the financial crisis. 

Rating Agencies 

As early as 2003, Warren Buffett, owner of Berkshire Hathaway Inc. and a respected US entrepreneur had raised the alarm about an impending crisis in the real estate caused by toxic mortgages. Even before an investor such as Warren Buffet took notice and made such an announcement, rating agencies such as Moody's and Standard & Poor's should have raised the alarm. Instead, these organizations continued to give positive ratings until mid-2008 when they raised the alarm bells. Their silence alongside other agencies enabled the situation to escalate as they did not warn investors about the impending danger (Thakor, 2015) . Further, their belated warning only exacerbated the situation. 

Borrowers and Federal Government Regulation 

Borrowers and federal government regulations played the same role of innocent third parties to the crisis, which in spite of their innocence still played an adverse role. It was government regulations such as the Community Reinvestment Act that made borrowers believe that every American had a right to own a home (Thakor, 2015) . Federal programs such as Freddie Mac and Fannie Mae acted as enablers for these borrowers to go ahead and borrow money to get their own homes. There was nothing wrong with the activities of this group, but it resulted in the initial surge in home prices. This price surge was taken advantage of by bankers and financial security traders as outlined above. 

Effects of the 2008 Financial Crisis 

Loss of Investor Confidence 

In any free economy, investor confidence is critical for the survival of the economy. Investors in a free economy only make investments because they want to, not because they have to. Wanting to invest is mainly based on a belief that the money invested will be safe and that the investment will have a positive return. The presence of these two beliefs is the basis for investor confidence. When banks began to collapse with billions of investments, when stock markets went on free fall, and when the economy began to collapse, investor confidence was severely affected. Loss of investor confidence augmented economic collapse and interfered with economic recovery. 

Collapse of Major Banking and Allied Sector Institutions 

The banking giant Lehman Brothers went bankrupt and sent the first shockwave in the banking and allied sector. Within weeks of the the collapse, it was discovered that Merrill Lynch, AIG, Freddie Mac, Fannie Mae, HBOS, Royal Bank of Scotland, Bradford & Bingley, Fortis, Hypo and Alliance & Leicester were also in trouble (Mathiason, 2008) . Had the latter banks not gotten external assistance, mainly from governments, they would also have collapsed. In the eyes of the investor world, they did indeed collapse but were saved . The collapse of the banking and allied sector changed the way these organizations operated, which adversely affected the global economy. 

Loss of Finances, Jobs, and Homes 

As a direct consequence of the 2008 financial crisis, billions of dollars in investments and stocks were lost by individual and corporate investors. As shown in the graph below, the stock market reacted to the financial crisis almost immediately and kept plummeting. Trillions of dollars were lost as a direct consequence of the same with some people losing their lives savings and pension (Gendron & Smith-Lacroix, 2015) . 

Many individuals who had used their homes as collateral lost them through foreclosure when the values of these homes plummeted. The American Dream that included a desire to own a home was a positive thing socially and economically, and the same was adversely affected when so many people lost their homes. Further, the loss of money also resulted in the loss of millions of jobs across the USA and the world as some businesses either downsized or collapsed. 

The Great Recession 

As a direct consequence of the 2008 financial crisis, the world economy went into what economists have dubbed as the great recession. The great recession started in 2008 and lasted until 2012 (Thakor, 2015) . It was characterized by global market downturns, reduced economic activities, poverty, and unemployment. The great recession eroded many gains that the global economy had gained in modern history due to factors such as globalization and information technology. 

Castigation of the US Government 

The George W. Bush government was blamed for doing nothing and allowing the US and the world to suffer the consequences of the financial crisis. The Barack Obama administration was blamed for using taxpayer’s money to the tune of billions of dollars to bail out companies that were affected by the financial crisis. In essence, the crisis created acrimony between the government and the populace which never augers well with economic growth and development. 

Rating Agencies 

Investment is an extremely complex process that a majority of investors do not even understand. Investors, therefore, rely heavily on investor agencies such as Moody's and Standard & Poor's to advise them on how to place their investments. These rating agencies suffered a major erosion of confidence among investors due to their perceived indifference to the gradually escalating financial crisis until too late. Lack of trust in these organizations also contributed to the reduction of consumer confidence (Blinder, 2015) . 

Government Bailouts 

No government in the world has ever had enough funds to cater for the needs of its citizenry hence the need for a careful balancing act in budgeting. In any fiscal year, the revenues available for any government, including the US are carefully shared out mainly into projects meant to aid the citizenry. Billions of dollars were taken away from the government budget and used to bailouts corporations that were facing collapse due to the financial crisis. This money was not generated but rather diverted from its intended use which was to benefit the citizenry (Blinder, 2015) . 

Actions Undertaken to Prevent another Financial Crisis from Taking Place 

Several actions including legislation have been undertaken to ensure that a repeat of the 2008 financial crisis does not happen. It is, however , important to indicate from the very advent that most commentators consider these actions as counterproductive. The 2008 financial crisis was not supposed to happen. It only happened because of breach of trust and dereliction of duties that happened in certain areas (Walters, 2015) . Instead of passing laws and undertaking measured that would adversely affect the economy, punitive measures on the guilty parties would suffice. The Obama administration enhanced the federal government role in the regulation of the economy and the private sector. This regulation was to be spearheaded by the Federal Reserve and was to extend even to the internal workings of the private corporations, more so in the banking and allied sector (Walters, 2015) . US Congress passed two Acts as a means of ensuring that a replica of the financial crisis does not take place in the future. These are the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Restoring American Financial Stability Act of 2010 (Nava, 2009) . The two Acts collectively ensured that whatever happened on the rundown of the financial crisis cannot happen unchecked in the future. However, they also place too much control on the economy of the USA thus, reversing the gains of a free economy. The two Acts create too much caution in corporate investments thus creating a manifest disadvantage to the US private sector players more so in the global market (Gendron & Smith-Lacroix, 2015) . 

Conclusion 

Taking a purely macroeconomic perspective, in 2008 the heavens fell resulting in one of the worst economic crisis in modern history, followed by the great recession. A global bank collapsed while several major banks and corporations almost went under and had to be bailed out by governments. By being bailed out, these institutions lost an element of autonomy as they were beholden to their respective governments. Based on the research outlined above, the 2008 crisis should never have happened. The US government believed that the economy was mature enough to manage itself, but unfortunately some unscrupulous organizations took advantage of the lack of oversight to act unethically in the mortgages sector. Toxic mortgages resulted and when the unscrupulous players were seen to make fortunes, many other players joined in creating a property bubble that would eventually burst. The burst precipitated the financial crisis. As indicated above, many steps have been undertaken in an attempt to avoid a recurrence of the crisis, but these steps only adversely affect the free global economy. 

References 

Blinder, A. S. (2015). What did we learn from the financial crisis, the great recession, and the pathetic recovery?.  The Journal of Economic Education ,  46 (2), 135-149 

Gendron, Y., & Smith-Lacroix, J. H. (2015). The global financial crisis: Essay on the possibility of substantive change in the discipline of finance.  Critical Perspectives on Accounting ,  30 , 83-101 

Gorton, G. B., Metrick, A., & Xie, L. (2015). An Econometric Chronology of the Financial Crisis of 2007-2008. http://dx.doi.org/10.2139/ssrn.2615029 

Lins, K. V., Servaes, H., & Tamayo, A. (2017). Social capital, trust, and firm performance: The value of corporate social responsibility during the financial crisis.  The Journal of Finance ,  72 (4), 1785-1824 

Mathiason, N. (2008, December 27). Banking Collapse of 2008: Three weeks that changed the world. Retrieved February 18, 2018, from https://www.theguardian.com/business/2008/dec/28/markets-credit-crunch-banking-2008 

Nava, P. (2009, December 23). Wall Street Reform and Consumer Protection Act of 2009: Bad for California. Retrieved February 18, 2018, from https://www.huffingtonpost.com/pedro-nava/wall-street-reform-and-co_b_401096.html 

Thakor, A. V. (2015). The financial crisis of 2007–2009: why did it happen and what did we learn?.  The Review of Corporate Finance Studies ,  4 (2), 155-205 

Treeck, T. (2014). Did inequality cause the US financial crisis?.  Journal of Economic Surveys ,  28 (3), 421-448 

Walters, C. (2015). Recession to Depression: A critical disambiguation of the 2007/2008 financial crisis and a model for new age securities regulation. HIM 1990-2015. 1752