Question

Causes of the 2007-2009 financial crisis and recession. Include:
a)   Relatively severity of the recession.
b)   Major causes discussed in the class notes, videos, and text.
c)   Actions the FED, congress, and president took to mitigate the crisis.
d)   “Take” on the crisis by the “Inside Job” video or alternative video on the crisis.
e)   Comparison of this crisis to the current ongoing COVID-19 recession.

Note that this is a short answer question, not a multiple choice question.

Answer 1

The monetary emergency of 2007–2009 was the culmination of a credit crunch that started in the late spring of 2006 and proceeded into 2007. By mid 2009, the monetary framework and the worldwide economy gave off an impression of being secured a plummeting winding, and the essential focal point of strategy became the counteraction of a drawn out downturn on the request for the Great Depression.

The main noticeable indications of issues shown up before the expected time 2007, when Freddie Mac declared that it would no longer buy high-chance home loans, and New Century Financial Enterprise, a main home loan moneylender to dangerous borrowers, petitioned for financial protection. Another sign was that during this time the ABX records—which track the costs of credit default protection on protections supported by private home loans—started to reflect better standards of default chance.

In early 2008, institutional failures reflected the deep stresses that were being experienced in the financial market. Mortgage lender Countrywide Financial was bought by Bank of America in January 2008. And then in March 2008, Bear Stearns, the sixth largest U.S. investment bank, was unable to roll over its short-term funding due to losses caused by price declines in mortgage-backed securities (MBS). Its stock price had a precrisis fifty-two-week high of $133.20 per share, but plunged precipitously as revelations of losses in its hedge funds and other businesses emerged. JP Morgan Chase made an initial offer of $2 per share for all the outstanding shares of Bear Stearns, and the deal was consummated at $10 per share when the Federal Reserve stepped in with a financial assistance package.

Causes of financial crisis

• Against a backdrop of abundant credit, low interest rates, and rising house prices, lending standards were relaxed to the point that many people were able to buy houses they couldn’t afford. When prices began to fall and loans started going bad, there was a severe shock to the financial system.
• With its easy money policies, the Federal Reserve allowed housing prices to rise to unsustainable levels. The crisis was triggered by the bubble bursting, as it was bound to do. Global financial flows have been characterized in recent years by an unsustainable pattern: some countries (China, Japan, and Germany) run large surpluses every year, while others (like the U.S and UK) run deficits. The U.S. external deficits have been mirrored by internal deficits in the household and government sectors. U.S. borrowing cannot continue indefinitely; the resulting stress underlies current financial disruptions.
• Securitization fostered the “originate-to-distribute” model, which reduced lenders’ incentives to be prudent, especially in the face of vast investor demand for subprime loans packaged as AAA bonds. Ownership of mortgage-backed securities was widely dispersed, causing repercussions throughout the global system when subprime loans went bad in 2007.
• “Throughout the housing finance value chain, many participants contributed to the creation of bad mortgages and the selling of bad securities, apparently feeling secure that they would not be held accountable for their actions. A lender could sell exotic mortgages to home-owners, apparently without fear of repercussions if those mortgages failed. Similarly, a trader could sell toxic securities to investors, apparently without fear of personal responsibility if those contracts failed. And so it was for brokers, realtors, individuals in rating agencies, and other market participants, each maximizing his or her own gain and passing problems on down the line until the system itself collapsed. Because of the lack of participant accountability, the originate-to-distribute model of mortgage finance, with its once great promise of managing risk, became itself a massive generator of risk.”
• The credit rating agencies gave AAA ratings to numerous issues of subprime mortgage-backed securities, many of which were subsequently downgraded to junk status. Critics cite poor economic models, conflicts of interest, and lack of effective regulation as reasons for the rating agencies’ failure. Another factor is the market’s excessive reliance on ratings, which has been reinforced by numerous laws and regulations that use ratings as a criterion for permissible investments or as a factor in required capital levels.
• Laws such as the Gramm-Leach-Bliley Act (GLBA) and the Commodity Futures Modernization Act (CFMA) permitted financial institutions to engage in unregulated risky transactions on a vast scale. The laws were driven by an excessive faith in the robustness of market discipline, or self-regulation.
• Risky financial activities once confined to regulated banks (use of leverage, borrowing short-term to lend long, etc.) migrated outside the explicit government safety net provided by deposit insurance and safety and soundness regulation. Mortgage lending, in particular, moved out of banks into unregulated institutions. This unsupervised risk-taking amounted to a financial house of cards. As institutions outside the banking system built up financial positions built on borrowing short and lending long, they became vulnerable to liquidity risk in the form of non-bank runs. That is, they could fail if markets lost confidence and refused to extend or roll over short-term credit, as happened to Bear Stearns and others.
• Many banks established off-the-books special purpose entities (including structured investment vehicles, or SIVs) to engage in risky speculative investments. This allowed banks to make more loans during the expansion, but also created contingent liabilities that, with the onset of the crisis, reduced market confidence in the banks’ creditworthiness. At the same time, they had allowed banks to hold less capital against potential losses. Investors had little ability to understand banks’ true financial positions.
• Federal mandates to help low-income borrowers (e.g., the Community Reinvestment Act (CRA) and Fannie Mae and Freddie Mac’s affordable housing goals) forced banks to engage in imprudent mortgage lending.
• Some firms separated analysis of market risk and credit risk. This division did not work for complex structured products, where those risks were indistinguishable. “Collective common sense suffered as a result.”
• New instruments in structured finance developed so rapidly that market infrastructure and systems were not prepared when those instruments came under stress. Some propose that markets in new instruments should be given time to mature before they are permitted to attain a systemically significant size. This means giving accountants, regulators, ratings agencies, and settlement systems time to catch up
• The complexity of certain financial instruments at the heart of the crisis had three effects: (1) investors were unable to make independent judgments on the merits of investments, (2) risks of market transactions were obscured, and (3) regulators were baffled.
• Behavioral finance posits that investors do not always make optimal choices: they suffer from “bounded rationality” and limited self-control. Regulators ought to help people manage complexity through better disclosure and by reinforcing financial prudence.
• In the post-2000 period of low interest rates and abundant capital, fixed income yields were low. To compensate, many investors used borrowed funds to boost the return on their capital. Excessive leverage magnified the impact of the housing downturn, and deleveraging caused the interbank credit market to tighten
• An interesting paradox arose, however, as credit derivatives instruments, developed initially for risk management, continued to grow and become more sophisticated with the help of financial engineering, the tail began wagging the dog. In becoming a medium for speculative transactions, credit derivatives increased, rather than alleviated, risk.
• U.S. financial regulation is dispersed among many agencies, each with responsibility for a particular class of financial institution. As a result, no agency is well positioned to monitor emerging systemwide problems.  
• Since traders and managers at many financial institutions receive a large part of their compensation in the form of an annual bonus, they lack incentives to avoid risky strategies liable to fail spectacularly every 5 or 10 years. Some propose to link pay to a rolling average of firm profits or to put bonuses into escrow for a certain period, or to impose higher capital charges on banks that maintain current annual bonus practices.
• Many investors and risk managers sought to boost their returns by providing insurance or writing options against low-probability financial events. These strategies generate a stream of small gains under normal market conditions, but cause large losses during crises. When market participants know that many such potential losses are distributed throughout the system uncertainty and fear are exacerbated when markets come under stress.

The economic upheaval caused by the COVID-19 outbreak has revived memories of the 2008-09 global financial crisis (GFC): recession chatter, bloodbath on global stock markets, governments and central banks loosening the purse strings.

The pandemic, which has claimed thousands of lives across continents, has virtually brought the world economy to a standstill with millions of people placed under lockdown and global supply chains thrown into disarray due to the virus wreaking maximum havoc in China — the world's factory.

Both crises share uncertainty as a key factor once they emerged in one of the two leading economies (the United States in 2008 and China end of 2019) and spread globally.

In a nutshell, subprime loans were granted to Americans with “Neither Income Nor Jobs & Assets” (NINJA) until 2007. The latter toxic risk was hidden and transferred via apparently sound securitized assets and financial vehicles so that nobody knew where and how significant the risk was. The result was a freezing of international financial relationships and a spike in uncertainty, including on the economic policies to tackle this unprecedented situation.

The COVID-19 crisis freezes a large chunk of merchant activities in half of the world.  The initial drops in the stock exchanges of major countries (up to one-fourth of their valuation) have been analogous between both crises. And both global recessions have been successively qualified as the largest since the Great Depression.

The impact on real gross domestic product (GDP) of the “Great Lockdown,” as the IMF calls it, depends on how long/strict the lockdown is and whether there is a quick rebound without COVID-19 relapses. Initial real GDP data for quarter one 2020 in the euro area and the United States contrast with annualized drops around 16 percent and 4.8% respectively. The larger drop in the euro area reflects the earlier shock and (often stricter) lockdown.

To limit such shocks,monetary and fiscal policies have in both cases provided massive support.

The spillover effects of the GFC were related to what were later called “Global Systemic Important Banks” (G-SIB) with contagion across borders. Similarly, the COVID-19 crisis has revealed the dependence of mature economies on some inputs produced only (or mainly) in other countries; this is perceived as jeopardizing their sovereignty. In both cases, there is a major comeback of the roles of the public authorities, the scope of regal (sovereign) powers, and the call for better regulations

The current exogeneous sanitary shock has affected, first, the real sector and the supply of production, then the demand side. In 2007-08 the endogenous financial shock affected the demand side first, and then morphed into the Great Recession of 2009.

The COVID-19 crisis has spread quickly all over the world given highly integrated supply chains and the physical contagion of the virus. This supply-shock then has affected the financial sector and the demand side (tourism, trade, etc.). As a producer’s constraint restrains the consumer, a demand shock emerges everywhere, worsened by psychological contagion.

The 2020 lockdown (self-quarantine at home) is identified with an “medically-induced coma,” voluntary and temporary, imposed on the economy so as to limit contagion (“flatten the curve’’). In order to minimize bankruptcies of firms and the loss of productive capital, including workers’ skills, it needs to be accompanied by medicines. In Europe more than in the United States, part-time work or technical unemployment subsidized by the governments are thus favored over firing massive numbers of employees. In addition, especially in Europe, public guarantees are provided to help banks provide the necessary loans to firms so as to survive the temporary coma.

By contrast, in 2008 the initial financial shock resulted in a burst of the housing bubble in the United States and, hence, of demand via wealth effects. Both then affected the US activity and international financial markets, leading progressively to a global recession. In order to avoid a “sudden death” of the economy, all actions were aimed at reviving finance to help the economy get out of its increasing lethargy.

In 2008, insufficiently capitalized banks were part of the problem. Financial institutions shall now be part of the solution. This is possible thanks to a better regulated financial system, despite earlier signs of reform fatigue and attempts to unwind regulatory progress in the recent years.

In theoretical terms, the current shock corresponds to a major leftward shift of the supply curve, followed by a resulting and possibly larger leftward shift of the demand curve. The previous shock corresponded first to a significant leftward shift of the demand curve followed by production anemia and, hence, a similar shift in the supply curve