Economics

What Caused the Financial Crisis of 2008?

The financial crisis of the late 2000s had a drastic impact on economies across the world.

What Caused the Financial Crisis of 2008?

The 2007-2008 financial crisis began in the United States and was caused by deregulations in many aspects of the world of finance. The deregulations allowed banks to engage in hedge fund trading with derivatives. The derivatives were profitable prompting banks to demand more mortgages; they opted for interest-only loans that were more affordable to subprime borrowers. Cheap mortgages led consumers to rush for houses causing a disequilibrium in the market because more people invested in real estates. An oversupply of homes in the market resulted in a drop in prices of houses and investors could not repay back their loans. The value of derivatives fell drastically and later crumbled. Borrowing between banks stopped and many of them were faced with a liquidity problem. Lehman Brothers, an investment bank collapsed and declared bankruptcy on September 15, 2008. The financial crisis in the US spilled over to other countries including the EU leading to the European Debt Crisis, and a global recession.

Deregulation

In 1999, the Gramm-Leach-Bliley Act pulled back the Glass-Steagall legislation permitting banks to two-party contracts even though economists argued that such an action would deter banks from competing with foreign institutions and only venture in low-risk securities. In 2000, the Commodity Futures Modernization Act permitted unmonitored trading of credit swaps overruling the law that cited such an act as gambling. Several members of Congress lobbied for the two bills including Senator Phil Gramm the then Chairman of the Senate Committee on Banking, Housing and Urban Affairs, Alan Greenspan the then Federal Reserve Chairman, and Larry Summers the former Treasury Secretary. The use of sophisticated derivatives made banking more competitive, and those more complicated products made more profits. They then bought the smaller banks and declared themselves “too big to fail.”

Securitization of Mortgages

Banks issued mortgages which they then sold to hedge funds on the secondary market. The hedge fund combined the mortgages with other similar mortgages and used computer simulated models to find the value of the bundle using the monthly repayment plans, the probability of repayment, the prices of the homes, and the probable interest rates. The hedge fund later sells the mortgages to investors. The bank can still loan out funds because it receives payments from the hedge fund. The bank collects the monthly repayment, sends it to the hedge fund who in turn would send it to the investors, along the chain, deductions in terms of commission are made. The transaction was risk-free to the bank but risky for investors who were covered by insurance companies under the "credit default swaps". Within a short time, many people were involved in derivatives including large banks, insurance companies, and in some instances even individual investors. Banks began issuing out subprime mortgages because they were risk-free and they had the cash to do so.

Raised Borrowing Rates

The 2001 March-November recession prompted the Federal Reserve to lower the Fed funds rate to 1.75% and 1.24% in November 2002. The interest rate on adjustable rate mortgages was also lowered. Homeowners who could not afford the contemporary mortgages were able to access the interest-only loans, and the value of the subprime mortgages rose by 10% to 20% of the total mortgage value. As at 2007, subprime mortgages were valued at $1.3 trillion. It created an asset bubble in 2005 as potential investors acquired loans to buy houses not to live but to own them hoping that prices would keep rising. Several investors did not realize that adjustable-rate loans would reset in three years and the Fed would raise the rates to 2.25% then to 4.25% and by June 2006, it had risen to 5.25%. House prices began falling as the interest rate increased and investors were unable to sell their assets or repay their loans leading to a bubble burst in the real estate industry causing the banking crisis of 2007 which later rippled to Wall Street and to other economies in 2008.

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