The 2007 – 2009 global financial crisis is one of the worst economic tragedy since the Great Depression that happened way back in 1929. The 2007-2009 crisis is also commonly referred to as a subprime mortgage crisis where the financial markets experienced a severe liquidity contraction originating from America due to the collapse in the US housing market (IMF, 2010). The crisis had the potential of halting the world mainstream financial system, led to an almost a stop of many major commercial and investment banks, insurance firms, mortgage lenders, and loans. Economists disagree and debate on the probable causes of the 2007/2009 financial crisis. However, there is a general agreement about the factors that contributed to its manifestation. This analysis specifically focuses on the primary causes of the crisis. The paper argues that the lack of regulation of the banking sector, which allowed for reckless banking contributed towards the 2008/2009 financial crisis (Kimberly, 2020).
Causes of the Crisis
The Fed and the American Central Bank foresaw a mild-recession, which started much earlier in 2001. In response to this anticipation, they lowered the fed funds rate eleven different times in the period 2000 May to 2001 Dec from a high of 6.5% to a low of 1.75%. This major drop in the fed funds rate allowed the banks to increase their consumer credit at much reduced prime rate permitting the institutions to even lend money to the high-risk customers referred to as ‘subprime’, lending to clients or general public all the time at higher than normal interest rates (Kimberly, 2010). The consumers were attracted by these cheap loans, buying houses, appliances and automobiles. The decreasing of the fed rates led to a housing ‘bubble’ in the 1990s. House bubble is a fast increase in house prices above their reasonable prices or intrinsic fundamental value as a result of high speculation. Figure 1 below shows the Fed action to reduce the fed fund rates on anticipating a micro-recession.
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Figure 1: Federal Reserve Historical Fund Rate 2000-2010
Source: ( FRED Economic Data, 2019) https://fred.stlouisfed.org/series/FEDFUNDS
As from the 1980s, there were several banking laws. Banks were in a position to provide subprime customers mortgage loans based on balloon payments, which are repayable by the clients on the closure of the loan period/ term. The adjustable interest rates remain relatively low for some predetermined period and normally float alongside the fed rate.
Provided the house prices continuously increase, the subprime mortgage borrowers make every effort to get protection against their higher than average mortgage payments through refinancing their loans, taking loans against their homes increased value or selling their houses at high profits and paying off their mortgages. Where there were mortgage defaults, the lending institutions repossessed the property and sold them at higher prices at which they offered the originally disbursed loan. Therefore, subprime loans became an attractive investment for several banks. The lending institutions took advantage of the situation and marketed aggressively to the poor credit customers or those with few properties, with a clear understanding that the borrowers were not in a position to pay back their loans and not give clear information about the involved high risk. The lending institutions, therefore, contributed to an increase in the subprime mortgages share amid all home loans from 2.5% to about 15% every year from the 1990s to 2004-2007.
Figure 2: Fed Historical Mortgage Lending Rate in the US 2000-2010
Source: ( FRED Economic Data, 2019) https://fred.stlouisfed.org/graph/?g=NUh
The increased practice of securitisation further promoted the increase in subprime lending. Securitisation is where the banks put together hundreds and thousands of subprime mortgages and other kinds of loans that are considered less-risky consumer debts and sold them as securities in the capital markets to investors and other banks as bonds. The banks sold these loans as pension funds and hedge funds, amongst others. Bonds that predominantly constituted of housing loans were now referred to as mortgage-backed securities, abbreviated as MBS, which guaranteed the buyers a share of principal payments and interest on the underlying loans. Selling the subprime properties in the form of the MBS was looked at as a perfect way to raise the bank liquidity and to minimise their exposure to loans regarded as high risk. Buying the MBS was perceived to be for the investors and banks to diversify investment options and to generate money. As the prices of the properties continued to increase through the to 2000s, mortgage-backed securities became very popular, and they experienced a rise in prices in the capital markets.
In 1999, the Glass-Steagall Act (1933) got repealed partially, allowing the banks' securities firms, banks and insurance firms to merge their markets and to join each other, leading to the creation of banks assumed to be too big to fail (Sher and Iyanatul, 2010). The banks were too big that thinking that they could fail was undermining the financial system. Additionally, in 2004, the SEC loosened its demand for net capital demand. The banks were motivated to inject more investments into the MBS further. Even though the decision by SEC led to enormous profits for these banks, the decision also exposed their portfolio to high risk, due to the fact the MBS asset value was implicitly destined on the housing bubble continuation.
Lastly, the long period for the global economic growth and stability that was experienced before the crisis, starting from the mid-80s to the late 1980s had persuaded several American government officials and banking executives and the economists that extreme volatility in the economy was a thing of the past. This attitude and the confidence and a climate that favoured deregulation and the ability of the banks to govern themselves, led to the ignorance of the signs of an impending crisis, with the banks continuing to lend recklessly, bad securitisation practices and high levels of borrowing.
In sum, the primary cause of the 2008/2009 financial crisis was deregulation for allowing the derivatives to be speculated on. It was further worsened by the support that was instigated low-priced mortgages that were offered even to the uncreditworthy persons. Rising poverty also led to the housing market bubble because many people were attracted to acquiring home loans. Also, raising of interest rates by FED consequentially squeezed the loanees repayment abilities leading to a resounding crisis that was witnessed in the housing sector bursting the bubble. Comparatively, the2008/2009 crisis resembles the stock market crash of 1929, in that there were asset markets were heavily indebted, credit was loose and reckless speculation in both. The crisis revealed that if banks fail to enhance regulations and the government shuns oversight, another crisis could still hit the world.
References
FRED Economic Data (2019). Effective Federal Funds Rate (FEDFUNDS). Accessed 17 Feb 2020 https://fred.stlouisfed.org/series/FEDFUNDS
FRED Economic Data (2019). 30-Year Fixed Rate Mortgage Average in the United States (MORTGAGE30US). Accessed 17 Feb 2020 https://fred.stlouisfed.org/graph/?g=NUh
IMF (2010). What Caused the Global Financial Crisis? —Evidence on the Drivers of
Financial Imbalances 1999–2007. Accessed 17 Feb 2020 https://www.imf.org/external/pubs/ft/wp/2010/wp10265.pdf
Kimberly A. (2020). 2008 Financial Crisis: The Causes and Costs of the Worst Crisis Since the Great Depression. Accessed 17 Feb 2020 https://www.thebalance.com/2008- financial-crisis-3305679
Sher V., and Iyanatul I. (2010). The Great Recession of 2008-2009: Causes, Consequences and Policy Responses. Accessed 17 Feb 2020 http://ftp.iza.org/dp4934.pdf
