The global financial crisis was a period during which downturns were experienced in the stock markets, economic activities as well as losses in the housing market all over the world. During this period, banks had to be bailed out by national governments and consumer wealth declined significantly. The result was a major recession between 2008 and 2009 .
This paper looks at the global financial crisis in the world, its effect in the US and measures taken by the US to manage it. This financial crisis was experienced in the world in the late 2000’s and the US was hit in different angles, the mortgage sector being among the worst hit. The result was a mortgage crisis that saw millions of people experience foreclosure and investors and financial institutions undergo major losses. This crisis saw key businesses fail, foreclosures went up (which reached their peak in 2008 through 2009 claiming 2.9 million properties) and unemployment rate was high. The unemployment rate was over 10% for the first time since 1983.
In the paper, I will also look at the reasons that caused the great crisis. Evidence has it that the condition was avoidable had the potential impact of the careless practices taken up by financial institutions been addressed. Financial institutions had been involved in extreme risk taking whose result was great losses on investments, subprime mortgages and securities that were backed by subprime mortgages .
Evidently, the onset of the mortgage crisis was the epitome of regulatory failure that allowed unwarranted greed to take root and result into excessive leveraging tendencies that eventually led to the burst of the housing bubble.
Beginning of the Collapse
The first trigger of this crisis was seen when the United States housing bubble burst. It took place between 2006 and early 2007. The mortgage meltdown was precipitated by easy availability of mortgages, and a boom in construction of housing . Credit had been made easily available as a result of a massive inflow of funds that were made possible by the Russian debt crisis and the Asian financial crisis which had been experienced by these countries between 1997 and 1998. The US’s fixed income from its worldwide investments also brought in much cash that amounted to $70 trillion. Consumer spending on credit was high, as well.
Other factors that contributed to this were credit conditions that were too easy. The interest on these loans was very low. Ineffective underwriting methods also contributed greatly to the crisis whereby 60% of mortgages that Citi had obtained were defective. These mortgages had not been underwritten in accordance to the laid down policies. It made it hard for the 1,600 financial institutions from which it borrowed to recover their money. Predatory lending was also common whereby financial institutions offered loans to people without making them understand the terms and conditions of the loans. Such institutions would provide vague information on their interest rates which the consumers only noticed after completion of the transaction .
Source: Financial markets and institutions, Fifth Edition.
The Hit of the Mortgage Crisis
The credit markets had frozen and the Federal Reserve alongside the central banks attempted to unfreeze the credit markets by investing $180 billion. The treasury secretary also proposed that all financial institutions should exclude bad mortgage loans be excluded from their balance sheets. Among the causes of the mortgage meltdown was the failure by borrowers to pay up their loans as a result of bankruptcy that saw the financial institutions that had given these mortgages experience huge losses. This was especially caused by mortgage loans that were securitized. A decrease in the value of subprime mortgages alongside the securities that backed exceeded $400 billion in 2007.
Financial institutions such as Citigroup, Morgan Stanley and Merrill Lynch experienced many bad mortgage loans that saw them write off $40billion in total. The Bank of America wrote off $3billion within the last four months of 2007 as a result of bad loans. Others were “Lehman Brothers” who experienced a $52 million loss from subprime mortgages or assets that were backed by these mortgages. Securities backed by mortgages also decreased in value and many financial institutions succumbed to the mortgage crisis. For example, in July 2008, FDIC seized the Indie Mac Bank who ranked at position nine in mortgage lending in the US. The drastic action was caused by the many mortgage defaults that were experienced and withdrawal of depositors .
On September 17th , 2007, the Dow dropped by over 500 points, which saw pressure build worldwide as stock markets experiences frequent fluctuations because investors were busy figuring out who would survive. Investors pulled out because of insecurity, even in the most secure investments. The result was a reduction of $144.5 billion in a day. The money market, therefore, reduced from $1.7 trillion to $52.1 billion in a week . Firms and factories, therefore, found it difficult to fulfill their short term financial obligations. The easiest solution was to lay off employees while others shut down completely. As a result, the unemployment rate rose drastically. By September 2008, even banks could not afford to lend each other any money. When they did the rates charged were extremely high. The financial markets froze, and so did the credit markets.
My Opinions Concerning the Mortgage Crisis
I think that the Crisis was avoidable and carelessness is what brought the US to the point. All the factors that resulted in the disaster were acts of negligence which any corporate institution should put a halt to whether a risk lurks or not. The heedless risk taking that Wall Street engaged in was a careless act as was the government’s failure to regulate financial institutions and government expenditure. The government for instance did not care to stop fraudulent loan givers. These were those institutions that advertised loans at low interest rates with unclear information concerning them, only for the people who took the loans to find the total amount of money to be paid back was much higher than that which had been projected.
The federal reserves had also relaxed and sat back as they watched people take up more loans than they should. Regulators should have taken the initiative to put a limit to the giving of loans despite the fact that the country had a lot of money at the time. They should have stopped the shoddy lending of loans as well as the risky bets that were made on the securities that backed these loans. There is always risk in betting on securities backed by loans. However, assuming that these risks will not affect anybody just because the current financial position of the country seems to be very favorable is a mistake because even accidents do happen.
I also think that had the Financial Crisis Enquiry Commission was at fault to operate while divided along partisan lines. As a result of the enquiry commission does not working in unison, inaccurate findings were reported which caused inaccurate analyze of the state of the country at that time.
The State was also at fault for not taking the crisis as seriously as it should have upon its onset and immediately put up measures to curb it. For example, I think President George Bush should not have waited until Lehman Brothers collapsed to intervene yet earlier on, the government had bailed out another bank. All financial institutions that were at risk should have been bailed out as early as possible because their collapse only worsened the condition of the state by increasing the level of unemployment.
The policy makers should have been selected based on their experience and forecasting of outcomes of certain actions to be put into serious consideration. For instance, the policy makers ignored the role that financial institutions played in the country’s economy. Less regulatory measures were enforced upon them and the financial institutions led by their greed indulged in excessive risks. The shadow banking system which included hedge funds and investment banks were ignored as opposed to institutions involved in depository banking which is the reason as to why they used off-balance sheet securitizations and derivatives that were too complex for a normal person to comprehend. These complex recording systems also proved to be of a disadvantage when determination of the exact financial position of such institutions was necessary because they were not consistent. This was the reason they experienced many losses like they did. Considering that these shadow banking systems provided credit to the US economy just like the commercial banks, the regulatory systems should have been equal for both.
The housing bubble and availability of easy credit saw many Americans own houses. The prices of houses were also booming at the time. However, as Congressman of the House Financial Services Committee, Ron Paul had said, house bubbles created artificially are bound to burst at some point. They are not sustainable for a long period of time. This was supposed to pose as a warning to put limits in the rate at which Americans owned homes on credit. Bursting of a housing bubble results in a decrease, in the value of property which is what happened during the financial crisis. It saw many people find themselves in a state of debt as their equity was wiped out.
It is clear that financial institutions had ignored all the warnings given concerning a possible recession from their careless financial methods. The warnings of analysts should be taken into consideration in any economy and the necessary measures taken into consideration to address the forewarnings. Had companies been more careful on their subprime investments in response to the waning given by a Merrill Lynch analyst on the potential negative impact that subprime investments could have on them, they would have reduced them and saved themselves from the losses that faced them during the onset of the crisis.
The government should have bailed out subprime borrowers in time before foreclosure of their homes as they dealt with the root causes of the situation such as the existence of predatory lending practices. Financial firms had been involved in the buying and selling of credits that they had not examined which resulted in many defective investments. This behavior can be owed to greed on Wall Street.
The main reason for the crisis according to me was the lack of regulatory policies on the practices of financial institutions, borrowers and investors. There was also a laxity in the prudency limits of lending out money among financial institutions which seemed to be hooked to excessive risk taking.
How the US dealt with the Crisis
The US Stimulus Plan
It was after a period of debate that both arms of Congress actually consented to pass the Economic Stimulus Plan and called it the American Recovery and Reinvestment Act on 13th February 2009. The funds catered for infrastructure and infrastructure projects, direct spending, and increment in unemployment benefits and increment in food stamps. Eventually, $212 billion was set apart to cover for tax breaks on businesses and individuals for that period.
The Financial Rescue Plan
The Obama administration also introduced a plan whose aim was to stabilize the financial system. Major financial institutions had little confidence in their assets and the US banks had failed through 2009. The financial rescue plan had several initiatives that included funding banks to increase their capital as well as buying “toxic” mortgages from the banks. It also intervened to prevent foreclosures. Its initiative was to expand the Fed’s Term Asset-Backed Securities Loan Facility (TALF), and promote the lending power of banks. This they did by providing securitized loans thus increasing investor demand. Better still, the Treasury which alongside the Federal Reserve birthed the Public-Private Investment Fund (PPIC) which was relieved by the FDIC and private investors. Financial institutions now had the opportunity to reduce their balance sheet risks by if they sold to PPIF. Their lending capacity and market functioning were also improved by this strategy .
A Solutions Chart
Government Rescue Efforts
The federal government applied considerable rescue efforts to the situation through 2009. It focused on restoring the liquidity of financial markets. A $700billion dollar bill was proposed and passed into law, by George Bush who was president at the time, on 3rd October 2008. This bill birthed the Troubled Asset Relief Program (TARP) that provided the US treasury with money to buy the “toxic mortgages” in an attempt to help restore financial institutions. The bill also required a plan to be devised on how to reduce home foreclosures by modifying loans.
The bailout of the three largest automobile companies (Chrysler, General Motors and Ford) would have resulted in a loss of 3 million jobs then . Federal Stimulus Programs were also designed to help save jobs and create new ones, as well. It was made possible by passing the Economic Stimulus Act for which it committed $168 billion. Guarantees of student loans were also available, and they amounted to $32.6 billion. The American Recovery and Reinvestment Acts were also established and to it attached $ 787.2 billion. Bailout money was also provided for companies to help AIG eliminate toxic assets. The Temporary Liquidity Guarantee Program, which saw the commitment of $308.4 billion being made, also helped in saving the financial sector.
In order to rescue the housing market and eliminate foreclosures, the Fannie Mae and Freddie Mac bailout that was done by an investment of $110.6 billion and the FHA housing rescue used up $20 billion.
Getting out of the Financial Rut
The government initiative to intervene saw many banks restructure their mortgage loans and avoid foreclosure. The Federal Reserve intervention in the housing market saw long-term mortgage rates drop to below 5 % for 30-year mortgages with a fixed rate. An example is that of Mae and Freddie Mac who suspended the intended foreclosure of 16,000 homes in 2008. They gave their borrowers a grace period of three months to see if they would respond positively to the new loan standards. Interest rates in other countries also dropped considerably during this period. Central governments worked hard to contain the recession that was building up. The United Kingdom, Belgium, Italy and Canada passed economic stimulus plans. For example, the Banks of England, Japan and Canada reduced their interest rates to 1% or less .
The federal government worked hard to revitalize the economy. For example, a Job Creation through Entrepreneurship Act was passed in May 2009. This act opened new channels for small businesses to obtain loans. Programs that saw a promoted rise in automobile sales were also established and they turned out to be a success. Changes were also made (in regulatory policies) to ensure that financial markets do not face such a recess (as this one) ever. They also ensured that every financial institution had the necessary funds to fulfill their financial obligations. Acts to reinforce these requirements were also laid out. The GDP had risen by 2.2 % by the third quarter of 2009 and reached 5.7 % in less than four months. With this improvement in the economy, the GDIA got to 10000 and the loss of jobs declined.
The mortgage crisis was avoidable as reported by the Financial Crisis Enquiry Commission in 2011. Financial firms were reported to have indulged in excess, unnecessary risks as a result of lenient corporate governance. The monetary policy of the US was also to blame for its lack of keenness in distribution of mortgages. Competition to lend resulted in a substantial decline, in standards of underwriting as well as risky lending. It was because of these reasons that defaults on mortgages had skyrocketed, which in turn resulted in withdrawal by investors. All the events that took place were mostly interconnected and would have crashed without intervention the financial markets.
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