Causes of Financial Crisis 2008 Essay

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The Financial Crisis of 2008

Introduction

The financial crisis of 2008, or the global financial crisis, is deemed the most serious the world has witnessed since the Great Depression. A crisis in the United States’ subprime mortgage market marked the beginning of the crisis back in 2007. It would then develop into a serious global banking crisis the following year when such huge financial institutions as the Lehman Brothers bank started collapsing. Its global financial impact was magnified when well established investment banks resorted to excessive risk-taking. In order to cushion the world financial system form a potential collapse, palliative fiscal and monetary policies were applied as financial institutions were accorded massive bailouts. This did not however prevent the Great Recession from happening thereafter. This paper explores some of the causes of the global financial crisis with a special focus on its greatest contributors.

In the period building up to the crisis, it was believed by financial institutions that regulating authorities would not let them into financial failure as this could result in a systemic risk that could negatively impact other sectors of the economy as well. A systemic risk is a situation whereby an entire complex system collapses due to the actions of the agents or entities making up the system (Arner, Avgouleas, Busch & Schwarcz, 2019). During the 2008 financial collapse, some of the largest and most important financial institutions to individual consumers and businesses were the ones that held loans that led to the eventual financial downfall. The moral hazard here was the expectation by these institutions that if a crisis were to arise due to a confluence of detrimental factors, the government would offer to their managements and owners special support or protection (Arner et al., 2019). It was presumed that some financial institutions were important to the economy so much that they could not possibly fail, especially added to the fact that they were big institutions. This assumption yielded a situation whereby the costs of the risks that were being taken by stakeholders were spread over to other parties as well, including buyers.  

According to analyses provided by economists thus, the U.S. financial system contributed the most to the 2008 financial crisis. Stiglitz (2010) explains that the system increased its funding to housing by providing hundreds of billions of dollars in this respect. Unfortunately, the houses that were so funded were not within the capability of many people to afford and were also not in the right places. The system chose to do massive lending in the housing sector at the expense of investing in productive enterprises. Players in the financial system further complicated the situation by creating risk instead of managing it. Of note here is that in spite of “supporting” housing in this manner, the transaction costs involved were enormous. That is, lending institutions sought to make more than normal profits in the process. As noted by Stiglitz (2010), almost 40% of profits made by corporations in the U.S. went to the financial sector prior to the crisis in 2007. However, this should have been worrisome to the economic players in the country since normally, the financial system should be a means to an end and not an end in itself. It was thus wrong to grow the financial system at the expense of other productive sectors. The system should not have decreased the productivity of the economy but should have instead increased it. The opposite happened and resulted into the crisis.

The mess was also blamed on rashly thought and implemented financial innovation. Financial products that were created by the innovation, though important, were so opaque and complex that it became impossible to price them correctly. Thus, when the boom came to an end, they all lost liquidity. As was observed by Crotty (2009), the products were inherently nontransparent due to their complexity. Since pricing them correctly became challenging as already noted, they could not be sold on markets and this explains why they became illiquid. In the first quarter of 2008 alone, the outstanding mortgage backed securities was worth $7.4 trillion. Compared to the whole fiscal year of 2001, this figure was more than double. On the same note, the amount issued as collateralized debt obligations had also significantly increased. While in 2004 the amount was just $157 billion, it increased to over $500 billion in 2006 and 2007 (Crotty, 2009). Giant financial institutions made large profits from the explosion of these securities. However, the situation also led to the destruction of the transparency that was needed for the market to be efficient. Securities not sold on markets were more in value than those that were sold.

Another factor that contributed to the crisis was lack of accountability in mortgage finance. Jickling (2010) points out that many of those who participated in the value chain of housing finance encouraged the development of bad mortgages and the selling of securities that were largely not good. Apparently, they felt that nobody would hold them to accountability for their actions. Exotic mortgages could be sold to home owners by a lender, with the lender not fearing any consequences if the mortgages failed. In a similar manner, toxic securities could be sold to investors by a trader without the trader fearing that those contracts could fail and they could be held personally responsible. So was the trend for such other actors as realtors and brokers. Each sought to reap maximally from their transactions and pass down the burden emanating from the transactions until the system could take it no more (Jickling, 2010). This was how the mortgage finance system in the U.S. became a risk generator instead of a risk manager.

The “originate-to-distribute” mortgage model that eventually failed was brought about by securitization and this means that securitization was another factor for the global financial crisis. According to Friedman (2011), securitization worked by allowing collateralized debt obligations, mortgage backed securities (MBS), and other derivatives to be sold by hedge funds and others. An MBS is a financial product that is priced based on the financial value of the mortgages serving as its collateral (Claessens & Kose, 2013). Once a bank gave a mortgage to a borrower, it would go on to sell the same mortgage to a hedge fund. After selling the mortgage in the secondary market in this manner, the bank could use the money it got to make new loans. It could still use the payments from the original borrower to make further deposits to the hedge fund. The hedge fund could then make this money available for their investors. This model widely dispersed MBS ownership so much that when subprime loans became unsustainable in 2007, the repercussions were felt by the entire global system.

Further, the world experienced the 2008 financial crisis partly due to deregulatory legislation. Amadeo (2019) stipulates that the unregulated risky financial transactions such as the ones already described, as were vastly practiced by financial institutions, were permitted by such laws as the Commodity Futures Modernization Act and the Gramm-Leach-Bliley Act. Apparently, the legislation were passed with the hope that the market discipline, especially in the U.S., was so robust that financial institutions would definitely exercise self-regulation. Upon the repealing of the Glass-Steagall Act and the coming into effect of the Gramm-Leach-Bliley Act in its place, it became legal for banks to make investments in derivatives using deposits. As per Amadeo (2019), the argument put forth by bank lobbyists in supporting this change was that it would make it easy for them to compete favorably with foreign banks. Their promise was that they would protect their customers by investing only in low-risk securities. Noteworthy, these complicated derivatives benefitted huge financial institutions the most in the sense that such institutions could become sophisticated through their vast resources. Interestingly, the more complicated the financial products of a bank were, the more money the bank made. This made it easy for the big banks to buy out smaller banks that were safer.

Conclusion

Although the 2008 financial crisis rocked the entire world, it majorly originated in the United States of America. The country’s financial system involved itself in some unsustainable financial practices a few years prior to the crisis. The situation was not helped by some laws that significantly deregulated the sector so that it became largely characterized by lack of accountability and transparency. As it turned out, the financial innovation that had been going on in the country for some time only served to sire complexities instead of simplifying the system and fostering economic development. The “originate-to-distribute” mortgage model backed by securitization was a complete failure that saw only a few big banks make abnormal profits at the expense of other sectors of the economy. This practice was further supported by the Gramm-Leach-Bliley Act and other deregulatory legislation. Hopefully, the U.S. learnt its lessons from the crisis and should therefore never again create conditions that would favor its reoccurrence.

References

Amadeo, K. (2019). “Causes of the 2008 global financial crisis”. The Balance. Retrieved May 23, 2019 from https://www.thebalance.com/what-caused-2008-global-financial-crisis-3306176

Arner, D. W., Avgouleas, E., Busch, D., & Schwarcz, S. L. (2019). Systemic risk in the financial sector: Ten years after the great crash. Waterloo, Canada: Centre for International Governance Innovation.  

Claessens, S., & Kose, M. A. (2013). Financial crises explanations, types, and implications. Washington, D.C.: International Monetary Fund.

Crotty, J. (2009). Structural causes of the global financial crisis: A critical assessment of the ‘new financial architecture’. Cambridge Journal of Economics, 33, 563-580.    

Friedman, J. (2011). What caused the financial crisis. Philadelphia, PA: University of Pennsylvania Press.

Jickling, M. (2010). Causes of the financial crisis [PDF]. Washington, D.C.: Congressional Research Service. Retrieved from https://fas.org/sgp/crs/misc/R40173.pdf   

Stiglitz, J. E. (2010). Lessons from the global financial crisis of 2008. Seoul Journal of Economics, 23(3), 321-339.   

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