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The financial crisis of 2007-2008
American Middle Class

All You Need to Know about the Financial crisis of 2007-2008

The estimated reading time for this post is 508 seconds

The financial crisis of 2007-2008 has lasting economic impacts.  In the fall of 2008, the US gross domestic product (GDP) fell by 4.3 percent. Two well-researched academic papers proposed a different reason for the Great Recession.

The paper by Professor Baijnath Ramraika and Michael Benatar, titled “Real Estate Prices, Subprime Lending and Financial Crisis: Lessons from U.S. History,” focuses on economic policies that led to this crisis. These authors point out that the sub-prime lending frenzy experienced in the U.S. during 2006 was not something new as it had been going on since the 1930s. The housing finance market always played an essential role in the American economy as significant players such as mortgage companies Fannie Mae and Freddie Mac dominated this market.

After Eisenhower Administration introduced Federal National Mortgage Association (FANNIE MAE) in 1938 to provide incentives for banks to make more home loans and Government National Mortgage Association (GNMA, later called Ginnie Mae) in 1968 to purchase loans from banks so that they would have more funds available for new mortgages, this made it possible for homeowners to get an interest rate lower than the market rates. However, it created a moral hazard problem because of the implicit government guarantee behind these two institutions, which encouraged them to take high risks without worrying too much about penalties even when they are wrong. The authors pointed out that the financial crisis of 2007-2008 was not an accident but a result of bad economic policies over the years.

Signs for the financial crisis of 2007-2008

The term financial crisis of 2007-2008 refers to the collapse of large financial institutions, such as those due to the subprime mortgage crisis. Banks were faced with bad loans from the housing industry in many areas and reacted by tightening their lending practices. This reaction precipitated a credit crunch that ultimately led to a global banking panic which caused a drop in international trade and threw the world economy into a recession. The collapse of Lehman Brothers on September 15, 2008, was only one of many significant firms that have undergone bankruptcy reorganization or been acquired at fire-sale prices because of exposure to bad debts during the subprime mortgage crisis.

“Financial crisis of 2007-2008” is a countable noun phrase, so it is grammatically incorrect to write or say, “The financial crisis is.” To express the meaning of the sentence, one would have to rephrase it as either “There was a financial crisis in 2007-2008” or “2007-2008 saw a financial crisis.”

The financial crisis of 2007-2008 (also known as the global financial crisis and the 2008 financial crisis) is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s. It resulted in several bank failures, the collapse of large financial institutions, significant government intervention, increased regulation on several levels, and diminished investor confidence worldwide. The loss of key organizations involved in securitizing debt-such as certain credit rating agencies-helped demand increased accountability for data quality in this industry. Governments took drastic policy measures, including nationalizing whole industries, taking over functions performed by private firms, expanding existing ones, or creating new regulatory bodies; these steps were initially highly unpopular but are increasingly recognized as necessary, though not sufficient in themselves resolve the crisis.

It can be argued that these events could not have occurred in the absence of four significant recent developments in financial markets:

(1) The growth of complex derivatives known as “credit default swaps” (CDS), which derive their value from underlying reference securities upon which they are written;

(2) The rise of securitization resulting in an unprecedented pooling and tranching of liabilities;

(3) The high leverage or gearing ratio between 2000 and 2007, where capital ratios had fallen throughout the developed world; and

(4) The interconnection of financial institutions through complex supply-chain “linkages.” Yet, many participants were unaware of the size of the risks being taken. The combination of the excess money supply from the U.S. Federal Reserve, lax regulation, and failure to present a united front among world leaders caused financial markets in general and CDS markets, in particular, to ignore possible future problems until after the crisis had begun.

The interconnection between major financial institutions was especially significant as nearly all large banks, investment banks, and insurance companies have been brought to the brink of insolvency or bankruptcy due to their inability to resolve a liquidity crisis by liquidating assets at an acceptable price. In other words, even though there had been ample warning signs of impending troubles (from falling housing prices and unfavorable derivatives valuations), most organizations continued with business as usual until they were forced to discontinue their activities.

Events leading to the crisis included a subdued outlook for inflation and a series of deflationary shocks associated with the bursting of the dot-com bubble, 9/11 attacks, as well as dramatic increases in oil prices. The precipitating factor was a high default rate in the United States subprime home mortgage sector-where loans were offered to borrowers without consideration of their ability to repay. This unanticipated development exposed other parts of the shadow banking system to potential losses and triggered a global credit crunch. Global stock markets also posted heavy losses during September and October 2008, while business worldwide slowed significantly. Major trade centers experienced severe import penetration due to declining demand from U.S. consumers who were buying less than before and saving more.

The U.S. Federal Reserve, European Central Bank & Other Central Banks Response

As an attempt to mitigate damage, there was a growing consensus among central bankers for monetary easing. The U.S. Federal Reserve, the European Central Bank, and other central banks provided liquidity to illiquid financial markets. On October 16, 2008, Henry Paulson, Former Secretary of the Treasury, announced significant regulatory changes in the United States to strengthen CDS regulation. Specifically, these included making CDS trading fully transparent and centralized by mandating that all trading be done via electronic platforms. It also required trading partners not to sign “dealer-to-dealer” confidentiality agreements. Furthermore, it demanded that standardized trading protocols are enacted with strict requirements for confirmation, guarantee, and settlement procedures-in addition to requiring standardized terms for CDS documentation (to facilitate comparisons based on standard accounting conventions).

The U.S. federal government was unsuccessful in its attempts to contain the crisis. A “lack of confidence” in U.S. institutions, specifically the Federal Reserve and Congress, along with complex problems within mortgage markets (and not merely low-interest rates) were also factors that led to the intensification of the crisis. At the same time, some commentators attributed the financial collapse to greed or market fundamentalism, and others argued that growing macroeconomic vulnerabilities caused it.

Nevertheless, many national governments took steps to alleviate their countries’ economic problems, including fiscal stimulus packages (designed to spur increased consumer spending), expansionary monetary policies (which reduce interest rates), loan guarantees for small businesses, and other types of rescue financing where necessary. There were also various policy responses to the crisis. Some countries introduced bank rescue packages aimed at buying bad assets, increase financial liquidity and stabilize markets. To fight unemployment, some governments even chose to borrow money (by issuing bonds) to fund infrastructure projects that create new jobs because they recognized that there was a time lag between investments and productivity gains which, if handled correctly, could swamp any adverse effects of fiscal stimulus or monetary easing. Other nations opted for tax cuts to stimulate consumption, while still others decided to implement austerity measures (to save their country’s most prized financial investments).

According to Mark Zandi, this crisis can be attributed mainly to “the bursting of a real estate bubble inflated over the course of more than a decade.” The collapse of the U.S. housing bubble and its effects on financial markets and the real economy were behind, but reinforced by:

Concern over burgeoning deficits and debt levels resulted in a series of federal bailouts for mortgage lenders Fannie Mae and Freddie Mac and Wall Street giants AIG and Citigroup-all of which were at risk due to their involvement with high-risk mortgages that essentially defaulted as house prices fell.

On the one hand, some government officials argued that such assistance would encourage lending; on the other hand, others contended that it was needed since banks had curtailed lending (due to an unwillingness to take on risky loans), leading to a credit crunch (which further worsened economic conditions).

The crisis threatened the existence of some financial institutions. Key components of the U.S. financial system, including commercial banks, investment banks, insurance companies, and mortgage companies, either went bankrupt or were effectively taken over by the federal government because they had all borrowed too much money to be able to pay it back when due-which cannot happen if they are operating within their means (i.e., “solvent”).

The bankruptcy of Lehman Brothers on September 15, 2008, precipitated a crisis (“financial meltdown”) which has come to be widely regarded as the worst financial crisis since the Great Depression; international stock markets crashed in response while world trade was considerably disrupted (causing multi-year lows for worldwide GDP growth).

In the United States of America, there has been a recent economic crisis starting from late 2007 until today (2016). This economic catastrophe is known as the financial crisis of 2007-2008. During the surprising short-term macroeconomic performance, this event seemed incredible at first, but the economy was not as strong as it appeared upon closer inspection. In his article, “Financial Crisis of 2007-2008,” Robert Shiller makes it clear that this crisis is merely a symptom of a much larger problem. The real issue lies in the very foundation our economic system operates: human nature and psychology. This crisis is a failure in humanity, not economics.

According to Shiller, there has been a great deal of research into what leads people to make economically irrational decisions from an outside point of view. From this vast body of work, researchers have developed some basic principles to help understand how humans react during times of stress or uncertainty. (Shiller) This understanding creates a framework for predicting future behavior when there is a high level of uncertainty. Utilizing this framework, Shiller believes it is easy to see why many people fall into economic traps created by themselves and others.

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