Causes of the 2007-2008 Financial Crisis

Causes of the 2007-2008 Financial Crisis

The 2007-2008 Financial Crisis was a global financial crisis that started in the United States and affected countries with exposures to the American financial system, especially countries in Europe. Take note that this crisis was also part of the Great Recession, which was a period of economic decline observed in different world markets.

The Causes of the 2007-2008 Financial Crisis

Collapse of the Housing Market in the United States

Most economists would agree that the simplest reason behind the crisis and thus, the primary root causes of the financial was the problems in the American housing market. However, take note that this primary cause had more specific causes, related events, and implications.

The problem started with the emergence of a housing bubble during the early 2000s. There are three factors contributing to the growth of the bubble: emerging interest in mortgage-backed security, relaxed lending activities, and increased mortgage consumption by the public.

Banks or lenders did not only provide mortgages to the public. They also sell them to third party investors both in the U.S. and abroad as securities. These investors looking for low-risk and high-return investments bought mortgage-backed securities from the lenders.

Financial institutions essentially securitized these mortgages. Securities backed by mortgages were deemed safe for two reasons. First, prices of real estate naturally appreciate. Second, if ever homeowners defaulted from their loans, lenders could easily cease their real estate properties and resell them in the market.

Mortgaged-backed securities became attractive to investors. To exploit further the demand, lenders needed to make mortgages more available to the public. Hence, they relaxed their policies and made housing loans available to individuals with low income and poor credit. The entire relaxed lending practice was called subprime lending.

The public also started to become interested in investing in real estate due to relaxed lending policies, including lax requirement and low interest rates. More specifically, they secured loans from lenders to buy real estate properties and have them refurbished. Some of them hope they could resell their properties for profit in the future.

Housing prices increased not only due to natural appreciation but also to the high demand driven by lax lending requirements and low interest rates. Rising prices made buying and investing in real estate properties more appealing to the public and thus, made mortgage-backed securities more attractive to investors.

A housing bubble soon emerged due to rapid increases in the prices of houses. At the same time, homeowners were unable to pay their debts while those who wanted to resell their properties were unable to do so because income did not increase significantly. Defaults became pervasive, and houses were foreclosed and ceased by lenders.

The lenders were unable to resell the ceased properties because interest in real estate declined due to the weak purchasing power of the public. The result was an abundance of supply and low demand, thereby resulting further in the collapse of real estate prices.

Decreases in the prices of houses stirred defaults further. Homeowners essentially had loans that were more expensive than the real value of their properties. The bubble collapsed. Investors stopped buying mortgage-backed securities, and lenders were stuck with bad loans. By 2007, several established lenders had declared bankruptcy.

Problematic Activities of Banks, Lenders, and Investors

It is also important to consider the poor practices of financial institutions and investors as the more specific causes of the 2007-2007 Financial Crisis and essentially, the reason behind the emergence of a housing bubble and the collapse of the U.S. housing market.

Fraudulent mortgage underwriting practice was prevalent during the early 2000s. In his book, risk management practitioner and academic Mark T. Williams explained that subprime lending became commonplace as banks made it easier for individuals to qualify for loans. The standards for mortgage underwriting were intentionally lowered.

These banks deprioritized proof of income and assets while moving from full documentation to low documentation and further to no documentation. NINJA mortgaged that disregarded income, job, and asset verification became popular. Several banks also encouraged borrowers to be less honest in their loan applications.

Predatory lending is another purported cause of the U.S. subprime mortgage crisis and thus, the 2007-2008 Financial Crisis. It generally involves unscrupulous lenders encouraging borrowers to secure risky loans for inappropriate purposes. However, an article published by The Economist provided a more concise definition applicable to the housing and financial crises.

Accordingly, predatory lending in the U.S. housing market in the early 2000s was not about lenders forcing borrowers to default from their loans so that they could profit from ceasing their collaterals. During the popularity of mortgaged-backed securities, it is about lenders convincing individuals to take big mortgages so they can pocket the fees, and then passing the mortgage along up the food chain.

The study of Sumit Agarwal et al. tested whether predatory lending was a crucial element in fueling the subprime crisis by measuring the effect of a 2006 anti-predatory pilot program in Chicago on mortgage default rates. Note that this program involved housing chancellors monitoring and reviewing risky borrowers and risky mortgage contracts.

Results of the study revealed that the pilot program reduced market activity in half, particularly through the exit of lenders specializing in risky loans and through a decline in the share of subprime borrowers. In addition, the study suggested that predatory lending practices contributed to high mortgage default rates among subprime borrowers, raising them by about a third.

Overleveraging was another factor. Prior to the subprime mortgage crisis and the 2007-2008 Financial Crisis, financial institutions achieved high leverage using complex financial instruments such as off-balance sheet securitization and derivatives. Notable examples of these institutions were Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley, which increased their financial leverage from 2004 to 2007.

The complex financial instruments made it difficult for creditors and regulators to monitor these institutions and try to reduce their risk levels. Nonetheless, because they have become highly leveraged, these financial institutions had an increased appetite for risky investments while reducing their resilience in case of losses.

A Specific Note on the Shadow Banking System

Nobel Prize in Economics laureate Paul Krugman noted that the run on the shadow banking system as central to the cause of the crisis. He specifically mentioned that the lack of controls was a malign neglect and argued further there should be regulations on all banking-like activities. Krugman essentially traced the 2007-2008 Financial Crisis to the failure of regulation to keep pace with an out-of-control financial system.

As a backgrounder, the shadow banking system is a term used to describe the operations and activities of non-banking intermediaries that provide services similar to traditional commercial banks but outside normal banking regulations. The system also includes regulated intermediaries that perform unregulated activates.

Shadow banking essentially facilitates the creation of credit across the financial system minus regulatory oversight. Some examples of intermediaries not subjected to regulation are hedge funds, unlisted derivatives, and other unlisted instruments. In addition, examples of unregulated activities by regulated institutions include credit default swaps, securitization of vehicles, asset-backed commercial paper conduits.

The system grew considerably before the financial crisis because of their competitive advantage over the traditional banking system. However, the collapse of the housing bubble and the emergence of the subprime crisis created a run on the entire shadow banking system without the safety nets that protected traditional banks.

Note that unregulated intermediaries had exposure to traditional banks. For example, the Reserve Primary Fund was a money market mutual fund that provided short-term funding to Lehman Brothers. Bank and on-bank institutions had used these off-balance sheet entities to fund investment strategies. The onset of the crisis created panic in various parts of the shadow banking system that helped fuel a credit crunch in the real economy.

A June 2008 speech by Timothy Geithner, former president and chief executive of the New York Federal Reserve Bank explained that shadow banks underpinned the financial system as a whole. Additionally, these entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets.

Failure of Government Regulators and Ineffective Policies

The findings of the U.S. Financial Crisis Inquiry Commission published in January 2011 revealed that the crisis was avoidable because it was caused by the widespread failure in financial regulation, as well as the failure of the Federal Reserve to stem the tide of toxic mortgages. It also concluded that key policymakers were ill-prepared for the crisis because they lacked a full understanding of the financial system they oversaw.

Federal policies that supported homeownership was also blamed. In his articled published in the Wall Street Journal, Peter J. Wallison, a lawyer and a fellow at the American Enterprise Institute, noted that almost two-thirds of bad mortgages in the U.S. financial system were bought by government agencies or required by government regulations.

Wallison explained further that the U.S. government has been attempting to make mortgage credit available to low-income borrowers since the early 1990s while disregarding the prudent lending principles that had previously governed the U.S. mortgage market. Through the Federal Housing Administration, the government compelled lenders to relax their qualification criteria to provide loans to low-income earners.

On the other hand, a 2012 study by the Organization for Economic Cooperation and Development or OECD revealed that capital regulation based on risk-weighted assets encouraged practices designed to circumvent regulatory requirements and shift the attention of banks away from their economic functions.

Note that there are several laws passed to deregulate financial institutions. For example, the Depository Institutions Deregulation and Monetary Control Act of 1980 removed a number of restrictions on the financial practices of banks, thus broadening their lending authority, allowing credit unions and savings and loans to offer checkable deposits, and potentially lessening depositor scrutiny of the risk management practices of their banks by raising deposit insurance limit from USD 40,000 to USD 100,000.

The Gramm–Leach–Bliley Act of 1999 repealed provisions of the Glass-Steagall Act that prohibited a bank holding company from owning other financial companies, thus removing the separation that existed between investment banks and depository banks. The law essentially provided a government stamp of approval for a universal risk-taking banking model.

In December 2000, the Commodities Futures Modernization Act of 2000 was signed into law. It banned the further regulation of the derivatives market. Furthermore, in 2004, the US Securities and Exchange Commission relaxed the net capital rule, which enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages.

The Federal Reserves also lowered the federal funds rate target from 6.5 percent to 1.0 percent from 2000 to 2003. As a central monetary authority in charge of devising and implementing monetary policy, the lowering of interest rates encouraged borrowing. The Federal Reserves did so to soften the effects of the dot-com bubble of the late 1990s and the 9/11 Terrorist Attack.

Remember that economist Paul Krugman argued that the failure of the government to regulate intermediaries involved in the shadow banking system resulted in the emergence of a financial system that was out of control. The lack of controls allowed these entities to assume additional debt obligations relative to their financial cushion or capital base.

Takeaway: Understanding Causes of the 2007-2008 Financial Crisis

Based on the discussions above, the reason behind or the causes of the 2007-2008 Financial Crisis were complex. The phenomenon was essentially a product of the complicated interlinking among different factors ranging from banking practices and government regulation to investor behavior and consumption behavior.

In general, the crisis stemmed from the failure of the U.S. housing market due to the emergence and eventual collapse of a housing bubble and the subprime mortgage crisis. However, more specific analyses revealed intricate causes such as the problematic activities of banks and investors, the general public, the existence of shadow banking system, and the failure of the government to intervene through proper intervention.

FURTHER READINGS AND REFERENCES

  • Agarwal, S., Amromin, G., Ben-David, I., Chomsisengphet, S., and Evanoff, D. D. 2014. “Predatory Lending and the Subprime Crisis.” Journal of Financial Economics. 113(1): 29-52. DOI: 10.1016/j.jfineco.2014.02.008
  • Financial Crisis Inquiry Commission. 2011. The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial Economic Crisis in the United States. ISBN: 978-0-16-087727-8. Available via PDF
  • Geithner, T. F. 2008, June 9. “Speech: Reducing Systemic Risk in a Dynamic Financial System.” Federal Reserve Bank of New York. Available online
  • Krugman, P. 2009. The Return of Depression Economics and the Crisis of 2008. New York: W. W. Norton & Company. ISBN: 978-0393337808
  • Organization for Economic Cooperation and Development. 2012. “Systemically Important Banks and Capital Regulation Challenges.” OECD Economics Department Working Papers. DOI: 10.1787/18151973
  • The Economist. 2010, April 27. “Predatory Lending.” The Economist. Available online
  • Wallison, P. J. 2009, October 15. “Barney, Frank, Predatory Lender.” Wall Street Journal. Available online
  • Williams, M. T. 2010. Uncontrolled Risk: Lessons of Lehman Brothers and How Systemic Risk Can Still Bring Down the World Financial System. NY: McGraw-Hill Education. ISBN: 978-0071638296