The 2007-2008 Financial Crisis was a global financial crisis that started in the United States and affected countries with exposure 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 collapse in the United States that transpired from 2007 to 2008 was the problems in the American housing market. However, take note that this primary cause had more specific causes, related events, and implications. This illustrates not only the complexity of the financial system but also the interconnectedness of its components.
The problem started with the emergence of a housing bubble during the early 2000s. It is worth noting that there are three factors contributing to the growth of the economic bubble in the U.S. housing market. These are 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 American public to encourage investments in real estate properties. They also repackaged and sold these mortgages as securities to third-party investors both in the U.S. and other countries. These are called mortgage-backed securities. The investors that were attracted to these securities were looking for low-risk and high-return investments from lending institutions.
Financial institutions essentially securitized these mortgages. Securities backed by mortgages were deemed safe investments for two reasons. First, prices of real estate naturally appreciate in most cases. Second, if ever homeowners defaulted on their loans, lenders could easily cease their real estate properties and resell them in the market.
Mortgage-backed securities became attractive to investors. Hence, to exploit further the growing demand, lenders needed to make mortgages more available to the public. They did this by relaxing their policies and practices to make housing loans more available to a lot of individuals. These loans were even accessible to people with low income and poor credit scores. 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 requirements and low interest rates. More specifically, they secured loans from lenders to buy real estate properties and have them refurbished. Some of them hoped they could resell their properties for profit in the future.
Housing prices increased not only due to the natural appreciation of real estate properties in viable locations but also due to the high demand in the entire housing market. This demand was driven by both the relaxed lending requirements and low interest rates. Rising prices made buying and investing in real estate properties more appealing to the public while also making investing in mortgage-backed securities more attractive to investors.
A housing bubble soon emerged due to rapid increases in the prices of houses. However, at the same time, indebted homeowners were unable to pay their mortgages and those who wanted to flip their properties were unable to resell them because income did not increase significantly. Defaults became pervasive. Houses were soon foreclosed and ceased.
The lenders were unable to resell the ceased properties because the demand for houses declined due to the weak purchasing power of the public. These properties flooded the market with no interested buyers. There was a huge amount of houses sitting idle. The scenario in the U.S. housing market was characterized by an overabundance of supply and low consumer demand. This eventually resulted in the collapse of real estate prices.
Price depreciation further triggered defaults. Homeowners essentially had loans that were more expensive than the real value of their properties. The housing bubble burst. Investors stopped purchasing mortgage-backed securities. Lenders were stuck with bad loans. Several established lenders had declared bankruptcy beginning in 2007.
Problematic Activities of Banks, Lenders, and Investors
It is also important to consider and underscore the poor and even questionable practices of financial institutions and misdirected or misinformed decisions of investors as the more specific causes of the 2007-2007 Financial Crisis. These factors can also be regarded as the driving point and collective reason behind the emergence and further expansion of a housing bubble and the subsequent collapse of the housing market in the United States.
Fraudulent mortgage underwriting practice was pervasive during the early 2000s. This is called subprime lending. Risk management practitioner and academic Mark T. Williams explained in his book that subprime lending made it easier for individuals to qualify for loans. The standards for mortgage underwriting were intentionally lowered.
Several banks and lending institutions deprioritized proof of income and assets while moving from full documentation to low documentation and further to no documentation. The so-called “no income, no job, and no assets” or ninja mortgage that disregarded income, job, and asset verification as part of the know-your-customer protocol became popular. Other banks even encouraged borrowers to be less honest in their loan applications.
Predatory lending is another purported cause of the U.S. subprime mortgage crisis that triggered the 2008-2008 Financial Crisis. It involved unscrupulous lenders encouraging borrowers to secure risky loans for inappropriate purposes. An article published by The Economist provided a more concise definition applicable to the housing and financial crises.
Accordingly, during the early 2000s, predatory lending in the U.S. housing market was not about lenders forcing borrowers to default on their loans so that they could profit from ceasing and reselling their collaterals. It was more about lenders exploiting the popularity of mortgage-backed securities by lenders convincing individuals to take big mortgages so they could pocket the fees, and then pass the mortgage further 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.
Findings from the study revealed that the pilot program resulted in a significant 50 percent reduction in market activity. This decline was attributed to a decrease in the number of subprime mortgage borrowers and the exit of lenders specializing in high-risk loans. Additional findings from the same Agarwal et al. study further suggested that predatory lending practices contributed to a one-third increase in subprime mortgage default rates.
Overleveraging was another factor. Financial institutions had high leverage using complex financial instruments like off-balance sheet securitization and derivatives prior to the crisis. Notable institutions such as Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley increased their leverage from 2004 to 2007.
The complex financial instruments made it difficult for creditors and regulators to monitor the activities and decisions of financial institutions and attempt to reduce their risk levels or risk exposures. Nonetheless, because of their significant level of financial leverage, these institutions developed an appetite for high-risk investments. The drawback is that this riskier investment direction further reduced their resilience in the event of losses.
A Specific Note on the Emergence of Shadow Banking System
Nobel Prize in Economics laureate Paul Krugman identified the bank run on the shadow banking system as a key factor and central to the cause of the 2007-2008 Financial Crisis. He strongly criticized the lack of regulations, calling it a negligent oversight, and argued for extending regulations to encompass all banking-like activities. Krugman essentially traced the crisis to the failure of regulation to keep pace with an out-of-control financial system.
Take note that the shadow bank 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 and standardized banking regulations. The system also includes regulated financial intermediaries that perform unregulated activities.
Shadow banking essentially facilitates the creation of credit across the financial system outside of regulatory oversight. Unregulated intermediaries, like hedge funds, dealers in unlisted derivatives, and other instruments not traded on exchanges, are notable examples. Regulated institutions can engage in unregulated activities such as trading credit default swaps, securitizing assets, and managing asset-backed commercial paper conduits.
The absence of regulation gave the shadow banking system a competitive advantage over the traditional banking system. However, unlike traditional banks that have a better financial cushion, it was more vulnerable. The eventual collapse of the housing bubble and the emergence of the subprime mortgage crisis triggered a run on the entire system.
Several unregulated intermediaries were exposed to traditional banks. The Reserve Primary Fund was a money market mutual fund that provided short-term funding to Lehman Brothers. Both bank and non-bank institutions had used these off-balance sheet entities to fund investment strategies. The onset of the crisis triggered panic in various parts of the shadow banking system. This fueled further a credit crunch in the entire 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. These entities were considered more vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid, and high-risk 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 and the specific 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 were also blamed. In his article 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. Specifically, through the Federal Housing Administration, the government compelled lending institutions to relax their qualification criteria to make loans accessible to low-income earners.
Findings from another study conducted by the Organization for Economic Cooperation and Development or OECD in 2012, on the other hand, 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.
Numerous laws were passed and enacted to deregulate financial institutions. The Depository Institutions Deregulation and Monetary Control Act of 1980 broadened the lending authority of banks by removing several restrictions on their financial practice. This promoted the offering of checkable deposits. It also lessened depositor scrutiny of the risk management practices by raising the deposit insurance limit from USD 40000 to USD 100000.
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. This removed the separation that existed between investment banks and depository banks. It essentially provided a government stamp of approval for a universal risk-taking banking model.
Furthermore, in December 2000, the Commodities Futures Modernization Act of 2000 was signed into law. It banned the further regulation of the derivatives market. The U.S. Securities and Exchange Commission was also passed in 2004. It relaxed the net capital rule and enabled investment banks to substantially increase the level of debt they were taking on. This fueled the growth in mortgage-backed securities that supported subprime mortgages.
The Federal Reserves also lowered the federal funds rate target from 6.5 percent to 1.0 percent from 2000 to 2003. Hence, as a central monetary authority responsible for developing and implementing monetary policy, this encouraged borrowing. It 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 both the emergence and further expansion of a financial system that was both unstable and out of control. The absence of controls or oversights allowed these entities to assume additional debt obligations relative to their financial cushion or capital base or exceeding their safety net.
Takeaway: Understanding the Causes of the 2007-2008 Financial Crisis
Based on the discussions above, the reasons 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 factors and causes like the problematic activities of banks and investors, the attitude of the general public toward the housing market, the existence of the 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
