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Global Financial Crisis

The Global Financial Crisis in 2008 has affected the banking industries heavily specially in
America; the collapsed of Lehman Brothers in September 2008 sparked off the tsunami effect
that affected many other banks around the world. There were many factors that contributed to
the financial meltdown in 2008; however the key reasons were deregulation of policies,
growth of housing bubble, subprime lending and financial innovations.
Deregulation of policies
The root cause that contributed to the financial crisis was the deregulation of policies. The
Glass-Steagall Act which was introduced in 1933 was a policy that acted as a guard that
prevented banks from exploiting depositors. The advantages of this act were that it prevented
financial sector of becoming too influential in politics and to boost healthy competition
among both commercial and investment banks. However in 1999 the Gramm-Leach-Bliley
Act was introduced and it removed the walls between commercial and investment banks.
According to Luigi (2010), he suggested that the removal of the act was a political move
instead of economic reasons. Previously when the Glass-Steagall act was in place,
commercial banks, investment banks and insurance companies had different goals
respectively, but after the restrictions was removed the goals of all these companies became a
common goal. With the deregulation of policies, financial market gradually grew stronger
and it became so strong that politics was heavily influenced by it.
Another deregulation of policy that fuelled the crisis was the amendment of Community
Reinvestment Act in 1995. The amendment of this act enabled lenders not only able to avoid
the redlining of traditional criteria in lending, but also to ignore most of the criteria of credit-
worthiness in their loan decisions. Mortgages could now be any multiple of income; a
persons saving history was irrelevant; applicants income did not need to be verified; and
participation in a credit counselling programme could be taken as proof of an applicants
ability to manage a loan (Sternberg 2013). Due to this amendment of the Community
Reinvestment Act, many people took up multiple loans and mortgage companies did not
bother to do proper screening before approving of loans to lenders.
Growth of housing bubble
The prices of houses in the America had been increasing since the mid-1990s at an alarming
rate; this was due to the sudden increased in wealth throughout America. People were


spending more than saving as compared to before; majority of the people spent their wealth
on a bigger house and thus triggered the inflation of housing price and soon the housing price
market reached an unstable level. According to Ben and David (2008) the people in the
United States was unable to afford a house with the price of $500,000; the housing price was
inflated to the point that it went out of proportion. For the two decades until 2001, the
national median home price went up and down, but it remained between 2.9 and 3.1 times the
median household income, according to the Harvard Joint Center for Housing Studies. By
2004, however, the ratio of home prices to income hit 4.0, and by 2006 the ratio was 4.6
(Ben and David 2008). People could only take up mortgage loans because their salary was
not enough to cover for the inflated housing price.
Subprime lending
Due to the trend of owning a house during the housing bubble, many people with poor credit
ratings wanted to join in the trend of owning houses too. They took up mortgages known as
subprime mortgage which incurred higher interest rates because of the default risk that they
possessed. The subprime market exploded during this period, rising from less than 9 percent
of the market in 2002 to 25 percent of the market by 2005 (Dean 2008). The mortgage
companies were also very eager to earn their commission from securing a loan that they
approved loans to homebuyers even though they did not have a complete documentation of
income and assets.
Financial innovations
Mortgages were classified into grades and then sold to banks because they wanted higher
profits. The banks then bundled all the loans and created Mortgage Backed Securities (MBS)
which was then given a rating by credit rating agencies. According to Dean (2008), the banks
paid incentives to these rating agencies in order to request for a particular rating; this misled a
lot of investors into thinking that the MBS with high rating will provide steady returns. Banks
even came out with new financial instrument known as Collaterized Debt Obligations
(CDOs) which consisted of a mixture of good and bad mortgages and was segregated into
different layers with the promise of having the rights to first claims on payments for the top
tier bonds. Due to the fact that CDOs are relatively new in the financial market, credit rating
agencies was unable to do a thorough research on the CDOs. The credit rating agencies
often gave high investment ratings to CDOs that were largely filled with assets that were in
turn backed up by high-risk mortgages (Dean 2008).


These CDOs and MBS were sold to many people around the world; the chain reaction when
the housing bubble burst was unimaginable. Many mortgage issuing companies went
bankrupt, followed by banks and insuring companies. The federal government was forced to
intervene because if they did not lend a helping hand to the big companies that were in
trouble, the whole worlds economy would collapse.
The Federal Reserve of United States intervened and took control of Freddie Mac and Fannie
Mae; they also injected $85 billion into American International Group Incorporated (AIG)
which was on the brink of declaring bankrupt. The United States Treasury and Federal
Reserve began to work out a few monetary policies to prevent the further destruction of the
Lowering of interest rates
The first monetary policy was the reduction of its federal funds rates from one percent in
October to between zero percent to quarter of a percent in December 2008; this was the
sharpest cut since the great depression.
This decision was made because according to Rudebusch (2009) the lowering of interest rates
fell in line with the unemployment rates as well as the inflation rates in America. The Fed
has been able to ease the funds rate only about half as much as the policy rule recommends. It
is also persistent. According to the historical policy rule and FOMC economic forecasts, the
funds rate should be near its zero lower bound not just for the next six or nine months, but for
several years (Rudebusch 2009).
Quantitative Easing
The next monetary policy was the Quantitative Easing (QE) which occurred in three phases
from March 2009. The idea of quantitative easing was to purchase huge amount of long term
assets and keeping a large portfolio of government and private debt. By doing so, the Federal
Reserve would be able to reduce long term yields and thus increasing the efficacy of
monetary policy.
The first QE occurred in November 2008; initially, the Federal Reserve only planned to
provide minimal assistance to rescuing the economy in hopes that the move would help to
jumpstart the economy. The Fed announced on November 25, 2008, that it would purchase
up to $100 billion in agency debt and up to $500 billion in MBS to support housing markets
and foster improved conditions in financial markets more generally. The announcement


made no mention of reducing longer-term rates (Thornton 2012). The chairman of Federal
Reserve hinted that they might introduced the QE policy when he mentioned that the Federal
Reserve could stimulate market demand by purchasing long term treasury or securities in
substantial amount; he also mentioned that the Federal Government was prepared to increase
their purchase if there was a need to.
In March 2009, the Federal Reserve expended their rescue package and announced that they
would purchase an addition of $750 billion worth of MBS; secondly, they would also
purchases additional $100 billion worth of debt obligations from the mortgage companies.
Lastly, they would purchase $300 billion worth of long term treasury securities monthly for a
period of six month. By June 2010, the Federal Reserve held a total worth of $2.1 trillion
worth of MBS, agency debts and long term treasuries.
The second QE occurred in November 2010 when the Federal Reserve announced that they
would continue with their reinvesting purchases in the first QE. In the second QE, they would
purchase $600 billion worth of long term treasury securities at $75 billion per month.
In the third QE which occurred in September 2012, Federal Reserve announced that would
continue to buy $40 billion worth of agency MBS monthly until the economy turns better.
The Federal Open Market Committee (FOMC) also announced that the federal fund rates
would be maintained at between zero percent to a quarter percent throughout the mid of 2015
instead of the end of 2014. However in December 2012, the FOMC increased its purchases to
$85 billion.
In December 2013, the Federal Reserve announced that QE would be tapered due to the
positive economic data. The asset purchase was reduced by $10 billion per month from the
previous $85 billion and it was reduced to $65 billion. Bond purchases will be divided
between $35 billion in Treasuries and $30 billion in mortgage debt beginning in February, the
Fed said. It repeated that purchases are not on a preset course (Zumbrun and Kearns 2014)
On top of that, FOMC announced that the federal fund rates would remained the same as long
as unemployment rate went down as well as inflation rate was maintained at two percent.
Analysis of monetary response
Lowering of interest rates
Federal fund rates are commonly used by banks as a benchmark to interbank loans; the rate of
federal funds can affect the cost for borrowers when they want to take up a loan with banks.


The fundaments of lowering the federal funds rate is so that banks could have more money to
lend out in the time of crisis; consumers and companies that required the additional assistance
would be able to borrow money on lower interest rates as well. This would ensure that both
consumers and businesses would be able to continue their daily operations (Board of
Governors of The Federal Reserve System 2014).
This implementation was targeted at the hopes of reviving the economy and to free up more
credits; however, credits remained tight even after the federal funds rate was lowered.
Quantitative Easing 1
During the implementation of QE1, the Federal Reserves rationale in buying the loans was
to ensure that the credits would be available for consumers to support the activity in the
market and improve the conditions in the financial market. If QE convinces markets that the
central bank is serious about fighting deflation or high unemployment, then it can also boost
economic activity by raising confidence. Several rounds of QE in America have increased the
size of the Federal Reserve's balance sheetthe value of the assets it holdsfrom less than
$1 trillion in 2007 to more than $4 trillion now (The Economist 2014). The result of QE1
was that mortgage interest rates dropped significantly due to the buyback of MBS and other
instruments; the market generally sensed that the Federal Reserve was serious in solving the
economic crisis. Therefore the financial market did not continue to slide further, however the
recovery was slow.
Quantitative Easing 2
During the implementation of QE2, the aim was to boost economy recovery by increasing
business credits and assets price. However many people was expecting that the mortgage
interest rate will remained low because that was the initial aim of the QE; therefore, the
mortgage interest rate increased rapidly when QE2 was put in place. QE2 was only
successful insofar as it has increased business credit and raised asset prices. As we now see,
the economy has actually cooled during QE2. So soon after I told you the QE2 trade was
effectively over in late March, asset prices and bond yields started to come down as inflation
expectations plummeted (Harrison 2011). QE2 failed even though they were able to create
hype on bank reserves because their main motive was to achieve a low interest rate.


Quantitative Easing 3
When Federal Reserve introduced QE3, their aim was to make the banks in America filled
with cash so that they would be able to start lending money to consumers which in turn
stimulate the market. It is unlikely that the Fed will go back to the well for the same policy
since QE2 has proved ineffective. So now that the economy is weak again, it will up the ante
and target rates instead of specific easing quantities. This has the potential political benefit of
the Feds not having to expand its balance sheet. The Fed would essentially guarantee a rate
and let the markets move interest rates to that level (Harrison 2011).
The monetary policy that was implemented by Federal Reserve proved to be useful overall
even though QE2 did not perform up to what the Federal Reserve promised initially.
According to Svensson (2011), the fundaments of a good monetary policy consist of
stabilising the inflation rate and maximising of resources in terms of sustainability. The
Federal Reserves monetary policy is consistent with the expectation of Svensson (2011);
Federal Reserves goal in the monetary policy was to provide maximum employment and
stable price. Svensson (2011) also agreed that the buyback of assets benefitted the economy
and any objections raised should be ignored.
Another conclusion is that interest rate policy is not enough to achieve financial stability.
The policy rate is an ineffective instrument for influencing financial stability, and policy rates
high enough to have a noticeable effect on credit growth and house prices will have a strong
negative effect on inflation and resource utilization, even in sectors that are not experiencing
any speculative activity (Svensson 2011). The Federal Reserves monetary policy must work
together with the interest rate policy in order to achieve financial stability because the interest
rate policy is unable to work without the QE even though it would be able to show a
significant difference in both credit and housing market sector. Without the QE measures, all
the big companies would not be able to get a bailout and would be forced to declare bankrupt
which will cause widespread of panic throughout the world.
On the other hand, Dabrowski (2010) was not in favour of the QE specially QE2 because he
was doubtful as to the injection of $600 billion; he believed that it would not benefit the
people in United States because he believed that interest rates do not matter much when
people are worried about their jobs. The banks will be reluctant to lend money to consumers


and the consumers would be hesitant to borrow. Dabrowski (2010) believed that majority of
the $600 billion would benefitted abroad into other emerging markets.
If the U.S. wants to eradicate its high current account deficit than it must increase its net
savings rate; monetary easing will not help achieve this goal (Dabrowski 2010). He believed
that the monetary policy should be focused more on decreasing the deficit that the United
States is having instead of buying up all the deficits.


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