Economists and scholars spend years dissecting financial markets and evaluating the causes of booms and busts. Throughout United States history there have been multiple economic booms that were underestimated and followed by recessions. In the situation of the 2007-2008 global financial crisis many culprits have been identified as causes, such as loose monetary policy, credit booms, deregulation, over complexity, and greed. Since the economic boom was solely dependent on weak policies and misconceptions, this leads me to believe prevention was possible with adequate regulatory policy, risk assessment and clarifications for commercial banks.
The Federal Reserve uses monetary policy to control the supply of money in order to determine interest rates and manipulate currency values. Markets commonly favor lower interest rates because people are able to pay less for capital. When the capital costs decline, banks and other entities are able to build up leverage for financing activities. When banks become highly leveraged they begin to take on more credit and liquidity risks without providing addition collateral. This is sometimes in reckless proportions that drive institution into possible closure and the need for bailouts (Investopedia, 2012). At the turn of the century during the infamous “dot-com bubble”, the stock market was flooded with new investors trying to take part in the newest financial craze. These investments were overestimated and premature, and as the stock market crashed high interest rates nearly crippled the economy.
The Federal Reserve reacted by lowering the interest rates in order to stabilize the economy and aid in its recovery. In response, consumers, bankers and other investors took advantage of the cheaper borrowing costs and flooded the economy with capital (businessinsider, 2012). Aside from the United States, many countries’ economies behaved similarly and the global economy prospered. Cross-country borrowing and investing began to increase relative to the flow of capital. Historically cross-country capital exchanges happen at disproportionate levels and create global financial imbalances amongst countries (IMF, 2012). At this point domestic economies begin to blend and become globally dependent, increasing their vulnerability and sensitivity to market fluctuations.
At the start of the century the U.S. economy experienced a credit boom that was underestimated on regulatory, institutional and consumer levels. Low interest rates attracted consumers and increased the demand for asset acquisition. Real estate and other marketable assets increased in value (dailybeast, 2012). Traditionally investment bankers invested in Treasury bonds, but interest rates were so low the yields were not worth the investment. At this time there were drastic increases in home ownership and a booming market for mortgages. Investment bankers began to purchase individual mortgages as a means to acquire more debt leveraging to continue financing more mortgage purchases. These mortgages were grouped together with other comparable mortgages then they were reformed, rated and packaged as a marketable product known as a collateralized debt obligation (CDO). The CDOs had different levels of risk and returns based on the estimations of default probability (NY times, 2012).
To insure their investments, investors also purchased derivative instruments known as credit default swaps (CDS). Credit defaults swaps are known as insurance contracts that protect the investor’s investments by gambling on whether a company or homeowner will default on debt obligations. The CDO and CDS markets were not new concepts, but had never experienced this level of investing in prior periods. In the past consumers generally purchased a CDS to go along with their bond or CDO investment. Since the CDS markets were facing large potential returns, external investors began to flood the market without having any principal ties. As these markets began to take hold, there was a realization of finite number of qualified homeowners (Wikipedia, 2012).
Generally homeowners were required to meet certain qualifications in order to borrow funds for mortgages, also known as prime mortgages. Since the prime mortgage market had receded, lenders were encouraged to lower their requirements for lending and began to allow subprime mortgages. These less responsible homeowners began to default on their mortgages, which turned investment bankers’ stream of mortgage payments into empty houses. Increases in foreclosures raise the supply of available houses, which lowers the fair market values of houses. The prime mortgage homeowners were left with houses that were highly devalued relative to their mortgages and began to abandon their mortgage obligations. Mortgage lenders, investment bankers, and outside investors froze their activities, as they faced possible bankruptcy.
Deregulation is believed to be the underlying cause of all economic downturns, as its scope of responsibility reaches all markets. In the 1930s the United States experienced a bank crisis that sparked a widespread distrust in the banking system and people withdrew their money from the depository institutions overnight. The sudden retraction of the money supply from the economy caused many banks to close and the economy to suffer. The Banking Act of 1933, also known as the Glass-Steagall Act, was created to insure depositors’ savings and restore confidence through the limitation of bank security activities and the affiliations between commercial banks and securities firms(Wikipedia,2012). The Glass-Steagall Act was successful for many years, but grew to be disliked by the banking community. In the 1980s-90s the world experienced economic booms and recessions that fueled the banks preoccupation with regulation.
The Gramm-Leach-Bliley Act was enacted in 1999, this removed barriers in the market among banking companies, securities companies and insurance companies that prohibited any one institution from acting as a combination of an investment bank, commercial bank, and an insurance company(Wikipedia, 2012). This act repealed part of the Glass-Steagall Act of 1933 and allowed banks to function with limited regulation. During the House of Representatives debate, Rep. John Dingell argued that the bill would result in banks becoming “too big to fail”, which will result in a bailout by the Federal government.
In light of the most recent economic boom, investors demanded greater return yields from their investments. This search led many people and entities to invest in unregulated securities markets. In some securities markets there were no regulations available, because the securities were overly complex and dependent on the recently deregulated banking industry. Some examples of unregulated securities are credit default swap derivatives, collateralized debt obligations and predatory lending connected were tied to the housing bubble. This era of financial engineering and limited regulation could be the main cause for our financial crisis and its following recession.
The financial crisis cost Americans trillions in investment losses, home equity declines, unemployment increases and lost wages. The broad spectrum of the global financial system is complex and involves almost everyone. It is difficult to isolate the causes of the financial crisis to a short list, but many economists and scholars commonly agree and a select few major contributors to the crisis. Whether it be deregulation, loose monetary policy, or global financial imbalances; the economy must return to some state of normalcy. In response to any mistake all participants should learn from the crisis and attempt to cultivate a plan for prevention and sustainability.
* http://news.investors.com/ibd-editorials-on-the-right/103012-631374-financial-crisis-was-caused-by-bad-policies.htm#ixzz2DLcCmbVd * http://en.wikipedia.org/wiki/Gramm-Leach-Bliley_Act
* http://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932008 * http://www.imf.org/external/np/seminars/eng/2012/fincrises/pdf/ch6.pdf * http://www.imf.org/external/np/res/seminars/2010/paris/pdf/obstfeld.pdf * http://www.investopedia.com/terms/m/monetarypolicy.asp
* http://topics.nytimes.com/topics/reference/timestopics/subjects/c/collateralized-debt-obligations/index.html * http://en.wikipedia.org/wiki/Credit_default_swap
* http://www.businessinsider.com/the-consequences-of-easy-monetary-policy-2012-9 * http://www.thedailybeast.com/articles/2012/09/06/the-clinton-recession.html * http://thinkprogress.org/economy/2012/09/13/846281/financial-crisis-lost-trillions/?mobile=nc
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