The 2007-2008 financial crisis is rightly considered as one of the most devastating and yet confusing economic hurdles facing the world in the 21st century. It is claimed to have been attributed to the enormously misbalanced real estate markets, coupled with the debt bubbles that undermined the stability of the U.S. economy, launching the chain of global crisis reactions. Yet, it is wrong to believe that mortgages were the only driver behind the 2007-2008 financial crisis. It was a multifactorial phenomenon. In the words of Swift (2011), the discussed crisis was a play, in which numerous actors played their role. Basically, it is the pursuit of unreasonable profits that put the entire economy under threat and forced the Federal Reserve into using the extreme mechanisms of macroeconomic and fiscal action to stabilize the economy and stop the process of economic self-destruction at a global scale.
The financial crisis of 2007-2008 became a turning point in the economic history of the U.S. and the rest of the world. Numerous factors caused it. Its roots can be traced to the beginning of the new millennium, when the dot.com revolution and low interest rates came together to shape a particularly favorable environment for administering cheap but risky mortgages (The Economist, 2013). That was also the beginning of the new wave of irresponsible mortgage lending to irresponsible or risky borrowers (The Economist, 2013). As the scope and volumes of those risky mortgages continued to expand, large financial institutions including banks assumed a more active role in managing mortgage risks. The riskiest packages were translated into low-risk security options that were further organized into pools (The Economist, 2013). In the meantime, as the Federal Reserve kept interests rates low, most financial institutions were interested in leveraging higher returns from the riskiest assets (The Economist, 2013). The so-called “era of moderation” created a false vision of stability, which left little room for doubts that the situation would change in the nearest future. The mortgage bubble continued to increase, leading to crisis.
The crisis occurred in almost one day, even though a whole sequence of events predisposed it. The growing burden of mortgage on the U.S. economy exceeded its debt potentials. With the falling real estate prices, many debt holders started to question the financial consistency of their riskiest lenders (The Economist, 2013). Meanwhile, the price of credit-risk securities kept soaring, leading a number of financial and real estate giants to bankruptcy. AIG, a leader of the American insurance market, went bankrupt under the pressure of the bubble securities it had sold (The Economist, 2013). The Lehman Brothers followed. The amount of the money they had borrowed as part of the subprime mortgage epidemic in the U.S. was truly enormous. The borrowed money turned out being a disaster for the entire financial sector. It is also the borrowed money that launched the global crisis.
A popular opinion is that the private sector and its pursuit of unreasonable profits were at the heart of the 2007-2008 crisis. In many respects, private entities predetermined the direction of the macroeconomic changes in the U.S. and beyond. Swift (2011) offers several examples to justify this position. For example, Swift (2011) says that, in response to the growing demand for cheap borrowing, private entities jumped in to become the founders of the novel lend-to-sell-to-securitizers model. Apart from their obsession with quick profits, private entities were exempt from most Federal Security Commissions regulations and recommendations. They changed the balance of forces in the financial and real estate markets, supplying as much mortgage lending as they could, as long as it was profitable. By 2006, 56 percent of all securities would be backed up by private entities (Swift, 2006). That was the turning point in the evolution of the crisis. It was also the beginning of the new era of global macroeconomic growth.
Given the unprecedented speed and scope of the financial crisis, the Fed took the leading role in minimizing its negative effects nationally and globally. The first reaction was to provide additional resources to ensure high levels of liquidity, while reducing interest rates to almost zero (Kohn, 2010). The goal of the initial steps was to provide households with an easy access to cheap financial resources and encourage spending (Kohn, 2010). In the meantime, the Fed kept shaping public expectations of the country’s financial future. More regular economic forecasts were intended to guide the economic and financial decisions made by enterprises and households (Kohn, 2010). Yet, the Fed soon realized that those instruments alone could not effectively deal with the negative macroeconomic consequences of the subprime lending crisis. As a result, it started to purchase long-term securities in an attempt to increase the reserve balances and strengthen the banking system (Kohn, 2010). Eventually, the banking system ended up holding abundant reserve balances, which provided a solid groundwork for the speedy recovery after the financial crisis. Looking back to 2008, Kohn (2010) confirms that the Fed was successful at supporting banks and households, as they sought to preserve their liquidity. Nevertheless, it is still too early to say if all negative consequences of the 2007-2008 crisis have been eliminated.
To summarize, the 2007-2008 financial crisis was a product of multiple factors. An unprecedented increase in subprime lending, coupled with the pursuit of unreasonable profits by private entities, launched the global crisis spiral. The mortgage bubble grew enormously, causing a huge pressure on the U.S. economy. It is under this pressure of risk-protection securities that the financial and real estate giants started to go bankrupt. The Fed initiated a series of steps to minimize the negative impacts of the financial crisis on the economy. Its intent was to supply enough liquidity, so that households could keep spending their money, while banks and financial institutions could meet their obligations. In a short-term perspective, the banking system ended up holding affluent balance reserves. The long-term benefits of the Fed’s anti-crisis initiatives are yet to be determined.
- Kohn, D.L. (2010). The Federal Reserve’s policy actions during the financial crisis and lessons for the future. The Federal Reserve. Retrieved from http://www.federalreserve.gov/newsevents/speech/kohn20100513a.htm.
- Swift, J. (2011). Lest we forget: Why we had a financial crisis. The Forbes. Retrieved from http://www.forbes.com/sites/stevedenning/2011/11/22/5086/.
- The Economist. (2013). Crash course. Retrieved from http://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are- still-being-felt-five-years-article.