Most economists consider the global financial crisis of 2008 to be the worst blow to the global economy since the Great Depression of the 1930s. Despite some governments’ aggressive protection efforts, this event resulted in high unemployment, market uncertainty, and tremendous output shortages. Furthermore, one could suggest that the global economy still hasn’t fully recovered from it. Thus, the objective of this memorandum is to analyze the global financial crisis of 2008, its causes, and ways of avoiding it in the present time.
Causes of the 2008 Financial Crisis
The conventional understanding of the 2008 financial crisis blames everything on the housing market bubble. In 2006, the U.S. market housing prices started to drop. However, this decline did not worry investors, as they believed that the market was just adjusting to a more stable equilibrium. This take on the market situation would be correct if not some of the legal acts enacted in the U.S. In 1977, the U.S. Congress passed the Community Reinvestment Act, which had an objective of helping low and moderate-income neighborhoods to obtain bank credit. The statute had an underlying rationale of addressing some of the country’s social issues, such as a rapid growth of ghettos in the 1970s. In addition, in 1985, the U.S. Congress enacted the Gramm-Rudman Act, which allowed banks to trade investors highly profitable derivatives. These mortgage-backed securities required some collateral in the form of mortgages. Since world’s major credit rating businesses gave mortgage-backed securities the highest, safest score, the demand for these derivatives has constantly been growing, resulting in a greater demand for mortgages. Thus, around the time of the global financial crisis many global financial institutions held mortgage-backed securities, they were in pension funds, corporate assets, and mutual funds. Furthermore, there were some businesses in the market, such as AIG, that sold insurance in the form of credit default swaps. Insurance companies created an illusion that people were safe buying mortgage-backed securities. However, once derivatives collapsed, AIG realized that it didn’t have enough money to honor all swaps. Financial institutions were also in bad condition and, thus, a massive, widespread panic followed.
Though the issue seems to be quite complex and hard to understand, I will outline several of the possible causes of the 2008 global financial crisis. It is impossible to suggest ways of avoiding this financial disaster in the future without understanding what caused it.
Deregulation. The Gramm-Leach-Bliley Act, enacted in 1999, which repealed the Glass-Steagall Act of 1933. The later statute prevented commercial banks from using their depositors’ reserves for risky investments, such as the stock market. Thus, the Act separated commercial banking from investment banking.
The idea was to help the U.S. banks to establish a competitive advantage in comparison to the foreign investment institutions, which had already used similar financial products (Amadeo, 2015).
Mortgage-backed securities. Amadeo (2015) presents a thorough explanation of the mechanics behind this complex financial product. The author defines a mortgage-backed security as “a financial product whose price is based on the value of the mortgages that are used for collateral” (Amadeo, 2015, para. 9). Once an individual gets a bank mortgage, the financial institution sells it to the hedge fund on a secondary market. Hedge funds combine mortgages, based on various analysis metrics, and sell them to investors. Thus, the procedure is very profitable and risk-less for commercial banks and hedge funds. Furthermore, banks get an opportunity to make new loans and repeat the cycle. Investors did not worry about risks too much, as they believed they were covered by credit default swaps, offered by well-known insurance companies, such as AIG. The profitability of these deals drew up the demand for mortgages. Financial institutions lost their focus and started offering subprime mortgages to just about anyone, as they made money on derivatives, not the loans.
The Federal Reserve’s inconsistent monetary policy. To overcome the 2001 recession, the Federal Reserve Bank had to lower interest rates. Some of the households that couldn’t afford to buy a house were now able to be approved for the interest-only loans. Thus, the percentage of subprime mortgages doubled from 10 percent to 20 percent of all mortgages during the period 2001-2006 (Amadeo, 2015). Once the Federal Reserve Bank started raising the interest rate to achieve some of its other macroeconomic objectives, there were a lot of households that couldn’t afford to pay interest on their mortgages. Furthermore, a decline in housing prices prevented households from selling their homes.
The analysis above presents a thorough tool for understanding of the 2008 global financial crisis’s causes. Some economists might outline other reasons; however, in my opinion, deregulation, mortgage-backed securities, and an inconsistent monetary policy are the primary factors to blame for the greatest financial disaster since the Great Depression. Once mortgage-holders defaulted on their payments and there was no activity on the housing market, financial institutions that held mortgage-backed securities found themselves in serious trouble. Some of the investment institutions, such as Lehman Brothers, collapsed, causing a massive, wide-spread market panic and the beginning of what we all know as the 2008 global financial crisis.
Increased regulation of banks’ activity. In my opinion, the repeal of the Glass-Steagall Act was one of the critical mistakes, which led to the 2008 global financial crisis. Banks’ investing and commercial activities should be separated, as it will prevent the greed from taking over the financial institutions. The majority of banks’ funds consist of their clients’ money; thus, by making some risky investments, banks endanger not their stability only, but also the stability of households that entrusted their savings to these financial institutions. The U.S. government should not necessarily restore the Glass-Steagall Act, but it could impose some regulations to control the structure of banks’ funds. For example, it could oblige banks to keep at least 30 or 40 percent of their money as institutions stockholders’ equity. This regulation would decrease banks’ willingness to take the risk and ensure better evaluation of the prospective investment options.
Credit agencies and other regulators. There are a lot of institutions in the U.S. market, both private and governmental, which are supposed to watch trends and prevent events, such as the 2008 global financial crisis, from happening. For example, SEC, the Securities and Exchange Commission, should have asked for a better disclosure of the securitization mechanics behind the credit default swaps. This simple request could have prevented insurance companies from creating an illusion that investors had nothing to worry about, as their investment decisions were backed up and safe. Also, rating agencies, such as Fitch Ratings and Moody’s, gave banks the highest credit rating possible, though loan packages should have looked suspicious to them. Thus, another recommendation is to ensure that market regulators, both government and private, work and do their job well.
The U.S. government must deal with shadow banking. The 2008 global financial crisis became a reality because many financial institutions wanted to make profits; thus, they did what was the best in their interest. Banks gave mortgage loans to households of various income levels. Furthermore, they later sold these loans to hedge funds, which collected them in groups and sold to investors. Also, there were insurance companies that wanted to make money by ensuring the security of institutions’ investments. Thus, in my opinion, there were too many intra-institutional transactions, which could have often been the shadow in nature. Government institutions should do a better job of regulating and controlling the market to prevent shadow transactions and the financial unrest from happening again.
- Amadeo, K. (2016). Causes of the 2008 Global Financial Crisis. The Balance. Retrieved 9 November 2016, from https://www.thebalance.com/what-caused-2008-global-financial-crisis-3306176