Causes of the 2007–2009 Financial Crisis

10 Key excerpts on "Causes of the 2007–2009 Financial Crisis"

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  Lessons from the Financial Crisis

  Causes, Consequences, and Our Economic Future

  • Rob Quail, Robert W. Kolb(Authors)
  • 2010(Publication Date)
  • Wiley

    (Publisher)

  A. G. (TASSOS) MALLIARIS

  Professor of Economics and Finance, School of Business Administration, Loyola University Chicago          

  The financial crisis that began in August 2007 evolved to become one of the worst since the Great Depression. Its severity within the financial sector and its significant impact on the real economy are extensive and well documented. Considerable research has also identified several contributing causes.

  The likely causes can be categorized in subgroups including factors rooted in macroeconomics (the decline in real estate prices), monetary policy (low interest rates during 2002 to 2004), microeconomics (subprime lending, opaque derivative securities, excessive risk taking, failed risk management strategies), and government deregulation (the abolishment of the Glass-Steagall Act, absence of regulation for credit derivatives). There are also institutional issues (problems with rating agencies, originate-to-distribute), global considerations (savings glut, fixed exchange rates for certain countries such as China), ethical violations (greed and corruption), and even psychological attributes (animal spirits). The collection of papers in this volume explores these issues and several more.

  The intensity, complexity, and length of the crisis justify the multiplicity and interrelatedness of causal factors. These factors are now weaved into analytical frameworks and empirical scenarios to facilitate our understanding of why and how it happened and to help us both discover ways to get out of it and avoid its reoccurrence. In this essay, we refocus the spotlight on a sequence of bubbles that were an integral part of the financial and economic landscape during the last decade and argue that their investigation can give us valuable clues, both about the occurrence of the crisis and its ultimate resolution. Another way to describe the contribution of this paper is to say that the global financial crisis of 2007-2009 has multiple subsets of causes, all contributing to an overall complex system, and we wish to propose that the formation of asset bubbles is a critical component that requires analytical attention.

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  Towards a Safer World of Banking

  • T.T. Ram Mohan(Author)
  • 2017(Publication Date)
  • Business Expert Press

    (Publisher)

  CHAPTER 2

  Causes of the Subprime Crisis

  America’s housing market had seen a rise in prices for several years until 2006. Thereafter, the bubble burst. Banks and other financial institutions that were heavily exposed to the housing market began to fail as a result, dragging the U.S. economy into a recession. As we noted in Chapter 1 , two hedge funds promoted by an investment bank, Bear Stearns, failed in July 2007, an episode that can be said to mark the start of the financial crisis of 2007.

  A collapse in housing prices has happened in several economies in the past, notably in Japan in the 1990s. The United States and other economies have been through many recessions before. What is striking about the financial crisis of 2007 in the United States is its sheer severity—it has stretched out for several years now and it has had a global impact. The financial crisis has come to be regarded as the biggest crisis in the United States since the Great Crash of 1929. The recession that followed and impacted the global economy is characterized as the Great Recession.

  How do we explain the financial crisis of 2007 and the Great Recession that followed? One approach that is common is to ascribe the crisis to a large number of factors. This has come to be known as the “Murderon-the-Orient-Express” theory of the crisis. Some of you may have read Agatha Christie’s novel of that name or seen the popular movie that came out of it. In the novel, one character gets murdered while taking a trip on the Orient Express, a train that ran from Istanbul to Paris over several days. Twelve stab wounds are found on him.

  The detective Hercule Poirot investigates the murder and solves it before the train reaches its destination: The murder was committed, not by 1 individual, but 12 individuals, each of whom had reason to loathe the murdered man. There were thus 12 villains in the picture. We can similarly identify 12 villains widely believed to have caused the financial crisis of 2007. These are:

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  Road to Recovery

  Singapore's Journey through the Global Crisis

  • Sanchita Basu Das(Author)
  • 2010(Publication Date)
  • ISEAS Publishing

    (Publisher)

  2 Global Financial and Economic Crisis: Causes, Impact, and Policy Response The global financial turmoil surfaced in the middle of 2007 as a result of defaults of sub-prime mortgage loans in the United States. It was blown into an unprecedented financial crisis in 2008 when a series of major financial institutions in the United States and Europe started to fail. Around the world stock markets fell, financial institutions were bought out, and massive coordinated actions by the authorities were taken to inject liquidity into money markets and restore confidence in the financial systems. Strong calls were made at the Group of Twenty (G-20) 1 level for a new financial system to prevent future financial crises and to maintain global financial stability. As the U.S. sub-prime mortgage crisis spread to the rest of the U.S. financial system and other industrialized-country financial markets, a significant slowdown was observed in economic growth of the U.S., Europe, and Japan. The financial sector crisis subsequently moved to the real economy. Although Asian financial institutionsʼ exposure to sub-prime-related products was limited, the impact was felt through capital flow and trade channels. Global Financial and Economic Crisis 17 Accordingly, the IMF in its World Economic Outlook (WEO) Update publication (January 2010) placed global growth at 3.0 per cent in 2008 and a contraction of –0.8 per cent in 2009. This represented a significant slide from an economic growth of 5.0 per cent observed in 2006–7. The advanced economies were in or close to recession in the second half of 2008 and early 2009, and showed some signs of recovery later in 2009. Growth in most emerging and developing economies was below trend, although key emerging economies in Asia, like China and India, showed higher resiliency. Genesis of the Global Financial Crisis The global financial crisis was triggered in August 2007 when the U.S. sub-prime loan defaults began to rise and foreclosures increased.

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  Financial Globalization

  Growth, Integration, Innovation and Crisis

  • D. Das(Author)
  • 2010(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  2. Principal contributing factors An unmitigated disaster of this magnitude characteristically does not have one or two causal factors or lapses. Therefore, identifying the ele- mental causal factor of the crisis is not possible. Several factors coalesced and together they were responsible for the crash of 2008. While mul- tifarious, these causes were interrelated and in many cases they were also the causes and consequences of each other. The seeds of the crisis were planted in the past. The beginning was the financial and payments imbalances in the global economy which steadily grew (Section 8.2). Huge inflows of external capital into the US economy were respon- sible for low real interest rates in the US during the first half of this decade. Accommodating monetary policy and excessive liquidity were explained by these capital inflows and global payments imbalances. The so-called ‘global saving glut’ supported the low US interest rates. Little was done to offset the imbalances, albeit they were being constantly analyzed in the academic fora and debated in supranational institutions. Steadily worsening global financial payments imbalances proved to be tinder for the global financial crisis. The imbalances in the US econ- omy were particularly flagrant and deteriorated from year to year (Cline, 2006). Unsound policy configuration dangerously debilitated the global financial system. In the financial environment of low interest rates, financial markets went in search of high yields. Low interest rates were the source of easy credit conditions and cheap money that spawned a consumption binge in the US and some of the other high-income industrial economies. Excessively easy monetary policy by the Federal Reserve in the first half Global Financial Crisis 131 of the last decade helped cause a bubble in the housing prices in the US (Bernanke, 2010). In this macroeconomic environment sub-prime mort- gage and risky asset markets boomed.

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  The Global Financial Crisis

  From US subprime mortgages to European sovereign debt

  • George K. Zestos(Author)
  • 2015(Publication Date)
  • Taylor & Francis

    (Publisher)

  2

  CAUSES OF THE US SUBPRIME MORTGAGE CRISIS

         

  Introduction

  Several years have passed since the end of the recession caused by the subprime mortgage crisis in the US. The causes of the crisis are still subject to debate, and it seems they will always be disputed, especially among proponents of opposing politico-economic ideologies. The main disagreement between these opposing ideological groups is in regard to the degree of government intervention in the economy and, more specifically, the housing market. Most researchers, nonetheless, are convinced that both government and market failures played a major role in the formation of the US subprime mortgage crisis and a large majority of analysts agree that many factors were responsible. What follows in this chapter is a brief analysis of the most important factors that fermented the crisis. All of these factors are discussed and critically analyzed, though they are not presented in order of significance.

  The dot-com and the corporate scandals crises of 2000–3

  The dot-com and corporate scandals crises that occurred at the turn of the twenty-first century were preceded by the longest economic expansion in modern US history, the decade of the 1990s. This expansion brought the unemployment rate down to 4 percent, the inflation rate to about 2 percent, and generated federal government surpluses for the years 1998–2001.1 Several authors support the view that the US subprime mortgage crisis has its roots in the expansionary US monetary and fiscal policies, adopted to cope with the dot-com and corporate scandals crises, and the negative climate that followed the terrorists attacks of September 11, 2001. The Fed, after a sequence of incremental cuts, drove the federal funds rate, its main monetary policy instrument, from 6.5 percent down to 1 percent, a 42-year record low.

  The US federal government reduced taxes and increased expenditures during this period to prevent a further deepening of the anticipated recession. The expansionary monetary and fiscal policies of this time were effective as low interest rates and increased government spending triggered a boom. Output, income, consumption, and prices all increased during this period. Monetary policy was exceptionally effective because it boosted consumption of automobiles as auto companies were able to increase car sales by offering zero percent interest rate loans to finance purchases of new vehicles.

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  European Banking

  Enlargement, Structural Changes and Recent Developments

  • Ö. Olgu(Author)
  • 2011(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  As the financial bubble inflated, these rewards were enor- mous, sufficient to lead to the individual’s disregard of any feasible penalty, such as dismissal, when the bubble finally burst. Leverage grew to historically unprecedented levels, with even some commercial banks lending up to 30–40 times their capital, though, in many cases Global Financial Crisis and European Banking 175 their structural investment vehicles were formally placed in unregulated offshore locations. In particular, the immediate reason behind the financial crash was the collapse of the housing boom in the US, where house prices had increased by 50 per cent between 2000 and 2005, the largest boom in US history. It began to falter by mid-2006, and financial turmoil was then triggered by the rise in defaults by sub-prime mortgage bor- rowers, followed by an implosion of the market for securitized assets backed by such loans. It can be stated that the crisis had its roots in real estate and the sub-prime lending crisis as a consequence of enor- mous increase in values of real estate during 1990s and 2000s (see Figure 7.2). Moreover, increasing housing prices coincided with a period of gov- ernment deregulation that not only allowed unqualified buyers to take out mortgages but also helped blend the boundaries between traditional investment banks and mortgage lenders. Real estate loans were spread throughout the financial system in the form of collateralized debt obli- gations (CDOs) and other complex derivatives in order to disperse risk. However, the failure of rising home values and mortgage payments of homeowners forced banks to acknowledge huge write-downs and write- offs. These write-downs resulted in several banks having insolvency problems, with many being forced to raise capital or go bankrupt.

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  Developed Nations and the Economic Impact of Globalization

  • Ken Moak(Author)
  • 2017(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  167 The US-originated 2008 financial crisis pushed the global economy, particularly those in the West and Japan, into the “Great Recession,” an economic and financial crisis not seen since the 1930s’ Great Depression. In the 2008/2009 period, all major developed economies registered negative growth rates, ranging from −0.5 in the EU to −0.7%. 1 Since then, average annual growth rates in the developed economies have barely surged above 2%. 2 The developed countries’ weak economies reduced global economy to less than 3% since 2008. 3 China’s econ- omy, growing at nearly 10% annually before the crisis, dropped to 6.5% in 2008. 4 Because it affected the global economy, the financial crisis revealed the extent of world economic and financial connectivity. HOW DID THE FINANCIAL CRISIS HAPPEN? There are a number of theories regarding why the 2008 financial crisis occurred: US Federal Reserve’s low interest rate policy, excessive saving in Asia, over-leveraging or reckless financial management behavior, and unsustainable fiscal and monetary policies in the West are the most cited. 5 The majority of analysts point to reckless financial management, creat- ing excessive liquidity through over-leveraging of financial and physical assets as the most important cause of the crisis. Whatever the causes, the financial crisis doomed Lehman Brothers in September 2008, sending shockwaves through the global financial system, particularly that of the West. 6 Banks, governments, and consumers in the West found themselves CHAPTER 8 The 2008 Global Financial Crisis: Effects on the Global Economy © The Author(s) 2017 K. Moak, Developed Nations and the Economic Impact of Globalization, DOI 10.1007/978-3-319-57903-0_8 168 K. MOAK buried under a mountain of debts, culminating in a prolonged period of weak aggregate demand. Accounting for over 85% of the economy, it would be difficult for the developed countries to increase GDP growth without appreciable rises in domestic consumption.

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  International Financial Crisis, The: Have The Rules Of Finance Changed?

  Have the Rules of Finance Changed?

  • Douglas D Evanoff, George G Kaufman, Asli Demirguc-kunt(Authors)
  • 2011(Publication Date)
  • World Scientific

    (Publisher)

  Journal of Structured Finance , Spring, 71–80. Origins of the Subprime Crisis 91 This page intentionally left blank This page intentionally left blank 93 The Role of the Financial Sector in the Great Recession Michael Mussa* Peterson Institute for International Economics In the story of the “Great Recession” of 2008–2009, the financial sector plays a starring role. Excessive and imprudent expansion of credit, utilizing an array of complex financial instruments, fueled an unsustain-able boom, especially in housing in the United States. As the boom started to deflate during 2007, investors began to recognize previously underappreciated risks as well as fear widening losses to themselves and to financial institutions which held claims of increasingly dubious value. As the crisis evolved into 2008, grave doubts arose about the viability of some key institutions with highly leveraged balance sheets and complex connections to much of the financial sector. Government inter-ventions to stabilize threatened institutions, in the United States and elsewhere, and substantial easing of monetary policy by the Federal Reserve (but not initially by most other central banks) helped to stabilize the situation for a time. However, as economic conditions deteriorated worldwide in the spring and summer of 2008, fears about the viability of key institutions re-intensified well beyond their earlier scale. In mid-September 2008, the outright failure of Lehman Brothers and the threatened collapse within days of a number of other key institutions set off a global financial panic, in which even the most creditworthy private borrowers could not roll over their short-term paper and leading banks worldwide stopped lending to each other.

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  Foundations of Real-World Economics

  What Every Economics Student Needs to Know

  • John Komlos(Author)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  14    The Financial Crisis of 2008

  At the turn of the twenty-first century, the economy was about to experience the worst economic crisis since the Great Depression. The Meltdown of 2008 became a crisis that shook the very foundations of liberal democracy. The 2008 collapse of the house of cards built on mistaken dogmas and excessive amounts of hubris will become a watershed moment on a par with 1929. This was caused by the confluence of the Dot-Com bubble, the tsunami of globalization, and the subprime mortgage crisis. Adding to these problems was terrorism and the subsequent senseless invasions of Iraq and Afghanistan which drained tremendous amounts of money from the U.S. economy. “These are times that try men’s souls.”1 Unfortunately, our souls were not prepared for these challenges and we lacked leaders with FDR’s vision to lead us to safer shores. Speaking of 1929, John M. Keynes’ words ring true for our own time:

  [t]o-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time—perhaps for a long time.2

  What a poetic way to describe an economic slump! We, too, got ourselves into a “colossal muddle” and we, too, blundered in our economic policies, and we still do not understand or care to recognize the workings of the new economy. And yes, we have been wasting much of our productivity and will continue to do so for a long time. We would need a Keynes for our times, but one is not in sight.

  One serious problem was that by the twenty-first century the memory of the Great Depression had faded and consequently the accumulation of “irrational exuberance” was not taken seriously. That experience was no longer considered relevant. Even the Chairman of the Federal Reserve since 1987 and among the elders of finance, Alan Greenspan (who coined the above phrase), was barely a toddler in 1929. Anyway, we were so much smarter and more sophisticated that the past was irrelevant.

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  The Political Economy of Britain in Crisis

  Trade Unions and the Banking Sector

  • Christopher Kirkland(Author)
  • 2017(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  The fail- ures of domestic private financial institutions or global systemic factors 160 C. KIRKLAND were relegated to a secondary status. … In the liberal left press there was a stronger initial concentration on the role of private financial actors in authoring the crisis, and, in the case of the Guardian, its global nature. The shifting of the focus from a banking sector crisis to a debt crisis— along with the change of government in 2010—generated new notions of blame. It also produced a new, dominant, narration of the cause and effects of the crisis, whereby the levels of national debt were not a symptom of the crisis (increased through banking bailouts) but a cause of the crisis itself. Increasingly, the government sought to redefine the culprits of the crisis from those involved in the banking crisis and vir- tual meltdown to those who are/were dependent upon welfare spend- ing. The previous Labour government was accused of running a prolific spending spree and failing to “fix the roof while the sun was shining” (Osborne 2013b). However, as Martin Wolf (2013) in The Financial Times notes “the share of government spending in GDP in 2007, just under 40%, was almost exactly the same as in 1996, the last full year of the Conservative government of John Major”. Much of the discourse surrounding the crisis was created, repeated and changed for political gains. Blame for the bankers was more reserved, no mainstream political party created—or had the desire to create—a narrative which would result in widespread economic changes. Individuals were singled out for personal failures, yet the narratives concluded that with the right people at the helm the current pre-crisis growth model could be resurrected and, a rising tide would lift all boats. The crisis was presented in terms of individuals or individual banks with specific individual problems. Certain banks came to symbolise cer- tain aspects of the crisis—e.g.

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