Question

How do stock market crashes relate to market failure in the financial industry?

Answer 1

Below we understand the relationship between stock market crash and financial sector failure thru the example of economic slump of 2008.

Easy credit & escalating home prices resulted in a speculative realty bubble. Whilst the market crashed in 2008, the issue began years earlier.

In the late 90s, the Federal Mortgage Association began a crusade to make home advances accessible to borrowers having a low credit scoring.

Fannie Mae wanted everybody to attain the American dream of house ownership, irrespective of credit. Lenders who extended housing loans to high-risk borrowers provided mortgages with unconventional terms to mirror the increased probability of default.

The relaxed lending criteria fuelled the housing growth & consequent escalation in home values. Persons with bad credit & little-to-nil savings were provided loans they couldn’t afford. Meanwhile, financial institutions were repackaging these debts & marketing them to investors in the secondary market.

Whilst housing prices continued to escalate, the augmenting subprime mortgage market flourished . Because housing values rose so fast, the increase in home equity counterbalanced the bad debt build-ups. If any borrower defaulted, financial institutions could foreclose without taking any loss on the sale.

The resulting seller’s market implied that if house owners could not afford the payments, they could sell the home & the equity would take care of the loss.

A crisis was essentially inevitable. Once the realty sector slowed down in 2007, the realty bubble was ready to explode.

The stock market crashed ( 2008) because too many had persons had taken on advances they could not afford. Lenders relaxed their strict lending criteria to extend credit to persons who were not qualified enough. This drove up realty prices to levels which several couldn’t otherwise afford.

The stocking up of bad debt resulted in a series of governmental bailouts starting with Bear Stearns, an unsuccessful investment bank.

In September 2008, investment company Lehman Brothers collapsed due to its over exposure to subprime lending. It was the biggest bankruptcy filing in U.S.A history .

Later , the Fed declared another bailout. This time it was insurance firm AIG, which exhausted it cash participating in the subprime lending game.

Each bailout declaration impacted the Dow Jones, sending it plummeting as markets reacted to the financial instability. The Fed declared a bailout package, which momentarily boosted investor confidence.

The Senate voted against the banking bailout bill . The Dow Jones tumbled 777.68, the largest single-day decline in history . Worldwide markets were embroiled in panic, causing worldwide instability.

Congress finally passed the bailout bill in October, but the harm was done. The Labor Department reported huge employment losses across the board as the Dow continued its downward spiral.