Thought to have been the worst ever since the Great Depression of 1930s', the 2008 financial crisis impacted even the well established financial institutions. The housing market in particular suffered immensely from the crisis, resulting in unprecedented foreclosure and eviction both of which led to prolonged unemployment. The crisis has also been held responsible for failure in key business sectors, slide in economic activities and a major decline in the consumer wealth.
Fannie Mae, the nation’s biggest underwriter of home mortgages was under great pressure from the Clinton administration to mortgage loans. Banks too had been pressurizing Fannie Mae to empower them to provide loans to subprime borrowers.
Events that Led To the Crisis
In retrospection, the 2008 financial crisis seems to have resulted from a culmination of several factors. Personally, I hold the following reasons responsible for having cleared the path leading up to the recession -
Growth of Housing Bubble
Owing to an unprecedented hike in the real estate prices in the US, there were many homeowners who refinanced their homes at a lower interest rate. By 2000, over $70 trillion had accumulated in worldwide fixed income investment which sought higher yields than those that were being offered by the U.S .treasury bonds. This pool of money was directed to the mortgage market.
Easy Credit Conditions
Between 2000 and 2003, the Federal Reserve lowered the federal fund rate from 6.5% to 1.0%. Further, the terrorist attack in 2001 and efforts to combat perceived risk of strategies that were put in place to combat deflation ended up fueling housing investment rather than creating an atmosphere that could be conducive for business.
US Current Account Deficit
Downward pressure on interest rates created by a rising account deficit required the U.S. to borrow funds from other countries. This in turn caused the bond prices to shoot up and interest rates to plummet. The US government borrowed heavily from countries that were running in surplus, particularly the emerging economies in Asia and oil exporting countries. As a result, a lot of funds flowed into the U.S. through finance imports and created a demand for various types of financial assets, which in turn caused the prices of assets to rise and massively lowered the interest rates.
On their part, the foreign governments purchased treasury bonds and thus were able to avoid the direct impact of the crisis.
Fraudulent Underwriting Practices
By 2006, 60% of mortgages purchased by Citigroup were defective. In 2007, the defective mortgages increased to over 80% of the production. It was further established that 54 % of the loans did not meet the original underwriting standards. In addition, 28% did not meet the issuers’ standards. When GSEs stepped in, they forced the underwriters to repurchase defective loans.
This is described as a practice wherein unscrupulous lenders entice borrowers to enter into ‘’unsafe’’ secured loans for reasons that are not valid. Advertising such loans and making people believe that they were cheap caused many borrowers to fall into the trap. What it caused was creation of negative amortization, meaning consumers were duped into thinking that loans were cheap only to realize later that they were indeed expensive. Since this realization dawned long after the loan transaction had been consummated, there was nothing much that could be done to reverse the process. Ultimately, there came a stage when such loans caused the country's financial condition to deteriorate and led the office of the Thrift Supervision to seize the lender.
Further, a mortgage fraud in which former employees of Ameriquest were pushed into falsifying mortgage documents with the hope that they could sell them to Wall Street banks may have worsened the crisis.
A sudden increase in the price of commodities that followed the collapse in the housing bubble and the tripling of oil price between 2007 and 2008 served to further exacerbate the crisis.
The regulatory framework erred by not keeping in pace with financial innovation, thus prompting the role of shadow banking system to broaden. Courtesy of banking regulation that supported freezing of credit and encouraged unconventional business practices, the US economy moved further towards recession.
Due to lending and investment of huge sums of money into the property market, property prices finally shot up and caused an increase in the level of personal debt. Because debts rose faster than incomes, unfortunately many people were unable to keep up with the pace of repayment. Most of them stopped repaying and eventually the banks found themselves facing bankruptcy.
Failure to further constrain creation of private credit by banks was was also cited as one of the causes leading to the problem. This also explains why banks limited their own lending immediately after the crisis. Banks that had borrowed too much with the intention of speculating on rising prices had no option other than selling their assets to repay the loans. This led to a further drop in price owing to which the banks panicked and reduced their lending further, leading to a downward spiral and causing the economy to slide into recession.