The 2008 financial, also referred to as The Great Recession, comprises one of the financial crisis in the recent time that posed unprecedented financial challenges in many countries across the world. The 2008 financial crisis occurred despite massive efforts by the United States Department of Treasury and the Federal Reserve. During the 2008 financial crisis, there was a significant drop in housing prices and a high unemployment level among the younger people.
The cause of the 2008 financial crisis can be traced back to 2006 when the United States housing prices started falling for the first time in several decades. Many housing experts believed that the situation was temporary and the situation would be restored to the normal sustainable levels. However, they declined, considering the impact of an increasing number of homeowners and questionable credit approved for mortgage loans (Adelino et al., 2018). Some of the approved mortgage loans were over 100% of the value of the homes. Some experts believed that the community reinvestment act had compelled financial institutions to invest in subprime areas. Freddie Mac and Fannie Mae guaranteed the majority of the mortgages during the 2008 financial crisis. Shutting down these agencies could result in the collapse of the housing market.
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The financial system was deregulated by two laws which provided banks with an opportunity to increase their investment in housing. Banks resulted into lending to risky borrowers. This phenomenon eventually resulted to the crisis. The first regulation was the Financial Services Modernization Act. The act enabled financial institutions to use deposits in investing in derivatives. The banks did not keep the promise to invest only in low-risk securities (Ospina & Uhlig, 2018). The second regulation was the Commodity Futures Modernization Act. The act overruled many state regulations which increased freedom of financial institutions in managing their resources.
The high profits generated by the Mortgage-backed securities increased the demand for mortgages. The risky assets were bought by study pension funds, hoping that credit default swap insurance products could protect them from the risks (Ospina & Uhlig, 2018). The American Insurance Group sold the credit default swaps. Eventually, the derivatives lost value, and the declining cash flow could not enable them to honor all the swaps.
Financial institutions panicked in 2007 after discovering that they had to absorb the losses. There was a significant rise in costs involved in interbank borrowing. The effort of the Federal Reserve in pumping liquidity was futile. The 2008 financial crisis has a huge and unprecedented impact on the economy. Many investors sold off their shares of the investment bank (Adelino et al., 2018). The crisis resulted in a sharp rise in the levels of unemployment. The treasury secretary was directed by congress to take over Fannie Mae and Freddie Mac mortgage companies, costing approximately $187 billion.
In the efforts to prevent the crisis from occurring again, there is a need to review the current banking regulations. The European banks across the world need to understand the role of insolvency in the crisis rather than liquidity. There is a need to eliminate the current requirements on liquidity. Higher instability can be achieved through the imposition of high capital requirements on banks. This will support economic growth as well as safeguard the high levels of bank lending. A similar crisis can be avoided by restricting consumer leverage and improving consumer literacy.
The financial crisis in 2008 posed a huge challenge to many economies across the world. The crisis was characterized by a significant rise in the levels of unemployment and a significant drop in housing prices. A similar crisis can be prevented from occurring through reviewing banking regulations and elimination of liquidity requirements.
References
Adelino, M., Schoar, A., & Severino, F. (2018). The role of housing and mortgage markets in the financial crisis. Annual Review of Financial Economics .
Ospina, J., & Uhlig, H. (2018). Mortgage-backed securities and the financial crisis of 2008: a post mortem (No. w24509). National Bureau of Economic Research.
