Global Financial Crisis

Written by: Ge Wu, David Ramirez

Date Written: 01/21/2019

2008 Financial crisis was an economic meltdown the world had not seen since Great
depression in 1929. It led to the Great Recession. The unemployment rate fell. The housing
market collapsed. The cause of the global financial crisis was a combination of regulatory
policies and the market conditions at the time and the collapse of the housing bubble.

In the early 2000s, there was a period of low interest rates and low volatility. After the dot-
com bubble, the market was in turmoil. As an effort to stabilize the markets the Federal
Reserve lowered interest rates. The interest rate was astoundingly low, less than 1 percent.
Credit available and cheap. As a result, borrowing for both consumers and intuitions very
attractive. low-interested continued for many years. 1

The housing market started booming in the early 2000s. Consumers were buyi ng houses
like never before due to lower interest rates. The low-interest rate allowed homeowners to
get cheaper loans. As more purchase of homes grew, housing value rose. Consequently, this
led to a housing bubble. Historically, housing prices steady goes up, and it was a safe
investment. No one would think it would go down. 2

Traditionally, mortgage lenders would lend out money and hold on to the mortgages until
it is paid out. Banks started buying the mortgages up from the mortgages lender for fees.
Freeing mortgage lenders holding the mortgage allowed them to issue more lease. 3

The banks bought up mortgages from a mortgage lender. The mortgages would then get
bundled up and repacked into securities. These securities were known as mortgage -backed
securities or collateralized debt obligations. They fixed income financial products with low
risk and relatively high returns. These commercial products were then sold off to investors.
4

With low interest rates, investors started seeking alternative investme nts outside the
traditional asset class such as U.S Government bonds. Mortgage -backed securities and
collateralized debt obligations was a good alternative. They were seemly safe, and the
returns were good relative to the risk. Many institutional investors such as pension funds,

1 Perry, B. (2018). Credit Crisis: Foundations

2 Perry, B. (2018). Credit Crisis: What Caused the Crisis?
3 Perry, B. (2018). Credit Crisis: What Caused the Crisis?
4 Perry, B. (2018). Credit Crisis: What Caused the Crisis?
mutual funds, and insurance companies, as well as hedge funds, and banks fled from low
return bonds to these more profitable financial products. 5

Banks bought up mortgages from mortgage lenders and repacking them into mortgage -
backed securities. The mortgage-backed securities were in demand from investors as they
were a safe and sound investment and an excellent alternative to a traditional asset class
such as bonds, especially during the low-interest rate period. Bank was profiting from
commissions and fees from selling them. 6

As the demand for housing grew, homeowners housing value went up. The mortgage
lenders were profiting from lending out mortgages and then selling the mortgages to the
banks. The banks were profiting from buying these mortgages from the lenders, and
repacking into fixed income securities and selling them to investors. Investors who
purchased these securities were profiling from the securities as they were relatively high
return and low risk. Everyone from the consumers to the middlemen to the investors was
profiting from this cycle. 7

Since the Community Reinvestment Act (CRA) was introduced in year 1977, low and
moderate-income neighborhoods have easier access to mortgage loan. Borrowers must
have income that is 80% or below the median income for the area in order to be qual ified
for CRA-based mortgage. The loan underwriting standard was reduced by mortgage
lenders. Nisha (2016) suggested that the automated underwriting systems was expanded
to the subprime market, but overreliance lowered underwriting quality and lack of
comprehension made lenders underestimate the credit risks of these subprime mortgages.

During the period, there was an increase in mortgage loans were made to a household who
traditionally didn't qualify. These were households with poor credit history, low income,
and poor working history, thus more likely to default (subprime mortgages). Unlike
traditional mortgage loans where interest rates are fixed, these loans had adjustable
interest rates. The subprime housing owners nor the banks buying these mortgages saw
any risk. The worst that could happen is they sell the home as housing was in demand, and
prices were steadily rising. Many took out subprime mortgages during the housing market
in hopes to make a profit by ‘flipping’ the home. They hoped that the housing market would
continue to rise. 8

Lenders who have high exposure in subprime mortgages have to bear the loss due to rising
foreclosures when housing bubble burst since the second quarter of 2006 as illustrated by

5 Perry, B. (2018). Credit Crisis: What Caused the Crisis?

6 Perry, B. (2018). Credit Crisis: What Caused the Crisis?
7 Perry, B. (2018). Credit Crisis: What Caused the Crisis?
8 Perry, B. (2018). Credit Crisis: What Caused the Crisis?
the quarterly S&P/Case-Shiller index. [8] In addition to this, Moody’s, S&P and Fitch were
blamed for placing an AAA rating on these junk securities, claiming they were as safe as U.S.
Treasuries. 9

Securitization of subprime mortgage magnified the financial crisis. Bullard et. al. (2009)
explained that derivatives such as mortgage -backed securities (MBSs) were created by
redistributing the income stream from the underlying mortgage pool among bonds that
differ by the seniority of their claim. Bullard et. al. (2009) also mentioned that collateralized
mortgage obligations (CMOs) or collateralized debt obligations, were created by combining
multiple MBSs (or parts of MBSs) and then selling portions of the income streams derived
from the mortgage pool or MBSs to investors with different appetites for risk. According to
Razaki et. al. (2013), such Securitization will effectively transfer the default risk from banks
to the investors via those derivatives. Bullard et. al. (2009) also emphasize that rising loan
delinquencies during burst of housing bubble caused many MBSs and CMOs to defau lt.

Interest rates eventually climbed. Many mortgages loans began to default. As the housing
prices started to fall, people tried to sell their homes, making the making the offer bigger
and bigger, while the demand fell into a tailspin; making the offer bigger and bigger, while
the demand fell into a tailspin. This phenomenon caused the housing price to drop even
quicker. As the market value of housing fell, homeowners were incentivized to default on
their mortgage, because their home valued less in the market than their mortgages. 10

The policymakers and regulators intended to save the market, but their intention was not
executed entirely and fairly, and without foresight of consequence of partial
implementation.

At first, the Federal Reserve believed the subprime mortgage crisis would remain confined
to the housing sector. Fed officials didn't know how far the damage would spread. But The
Federal Reserve began pumping more liquidity into the banking system via the Term
Auction Facility. But that wasn't enough.

In March 2008, the Federal Reserve saved Bear Stearns with a last-minute $30 billion loan
supplied through JPMorgan Chase, but the Fed allowed Lehman Brothers to fail, which
triggered wide-scale financial panics. In hindsight, it would have been a small price to pay
to avoid the subsequent economic carnage.

Many legislators blame Fannie and Freddie for the entire crisis. To them, the solution is to
close or privatize the two agencies. But if they were shut down, the housing market would
collapse. They guarantee 90 percent of all mortgages.

9 Nisha, N. (2016). “Global Financial Crisis: Exploring the Special Role of U.S. Banks and
Regulations.”
10 Perry, B. (2018). Credit Crisis: What Caused the Crisis?
The FDIC traditionally insures all depositors and creditors against losses, irrespective of the
insurance limit. But the FDIC chose to only guarantee deposits up to $100,000 for IndyMac
Bank.

Doing so sent a shockwave of fear throughout the financial markets and played a leading
role two months later in the debilitating run on Washington Mutual. After that, banks found
it difficult, and in many cases impossible, to raise capital from anyone other than the U.S.
government.

The government must step in to regulate when seeing unusual market activities and must
add scrutiny to financial product innovations by understanding and explaining risk/loss
profiles. Pro-cyclical policies and Counter-cyclical policies must be monitored and not to be
abused when enforcing in the market.

The Congress passed the Dodd-Frank Wall Street Reform Act to prevent banks from taking
on too much risk. It allows the Fed to reduce bank size for those that become too big to fail
and address shadow banking issues, i.e., investment banks and thrifts that didn't fall under
the primary regulatory purview of the Federal Reserve, FDIC, or the Office of the
Comptroller of the Currency.

But it left many of the measures up to federal regulators to sort out the details. Meanwhile,
banks keep getting bigger and are pushing to get rid of even this regulati on. The financial
crisis of 2008 proved that banks could not regulate themselves. Without government
oversight like Dodd-Frank, they could create another global crisis. In short, crises like these
don't have to be inevitable. But they will continue to be so if every other generation's
leading financiers don't spend some time in the library learning about the mistakes of their
predecessors.

List of Reference:
Perry, B. (2018). Credit Crisis: Wall Street History. [online] Investopedia.
Perry, B. (2018). Credit Crisis: Foundations. [online] Investopedia.
Perry, B. (2018). Credit Crisis: What Caused the Crisis? [online] Investopedia.
Perry, B. (2018). Credit Crisis: Government Response [online] Investopedia.
Nisha, N. (2016). “Global Financial Crisis: Exploring the Special Role of U.S. Banks and Regulations.”
International Journal of Banking, Risk and Insurance, 4(1), pp. 53-63.
Razaki, K., Koprowski, W., and Ruzieva, M. (2013). “The Laxity Of OCC In Enforcing Regulations To Prevent The
Subprime Crisis.” Journal of Business and Accounting, 6(1), pp. 27-39. Eichengreen, and Barry. "The financial
crisis and global policy reforms." In Proceedings of the Federal Reserve Bank of San Francisco's conference on
Asia and the Financial Crisis. Santa Barbara, California, October 19-21, 2009, issue Oct, pp. 299-334.
Managing risk in financial institutions, seventh edition, Pace University Anthony Saunders-Marcia Cornett -
Mcgraw-Hill/Learning Solutions – 2011
Financial Markets, Institutions and Risks, ARMG Publishing in Sumy State University
https://www.fool.com/investing/general/2015/02/28/25-major-factors-that-caused-or-contributed-to-
the.aspx
https://www.thebalance.com/what-caused-2008-global-financial-crisis-3306176