Question

What caused the 2008 financial crisis? What do you consider to be the three most important factors? (Describe three and make an argument.) Use Stiglitz and White Reading and PP March 28 – financial crisis.

Answer 1

The economic crisis was caused largely by financial industry deregulation. Which allowed banks to participate in derivatives hedge fund trading. Banks then demanded further loans to finance these derivatives ' profitable selling. They generated interest-only loans that made subprime borrowers affordable.In 2004, as the interest rates on these new mortgages adjusted, the Federal Reserve increased the fed funds rate. Housing prices began to fall as demand outstripped the supply. That trapped homeowners who were unable to afford the payments, but were unable to sell their home. The banks avoided lending to each other when the derivatives ' prices crumbled. That created the financial crisis that resulted in the Great Recession.

1. Securitization- First, hedge funds and others sold securities backed by mortgages, collateralized debt obligations, and other derivatives. A mortgage-backed security is a financial product, the price of which is based on the value of mortgages used for collateral. If you collect a loan from a bank, it will sell it to a secondary market hedge fund. The hedge fund then combines a number of other different loans with your mortgage. On the basis of several variables, they used computer models to work out what the package is worth. Since the bank has sold your mortgage, with the money it has received, it can make new loans. It may still collect the fees, but it will give them to the hedge fund, which will send them to their investors. Everybody takes a cut along the way, of course, which is one of the reasons they have been so famous. For the bank and the hedge fund, it was basically risk-free.

The creditors took all the default risk, but because they had protection, called credit default swaps, they didn't worry about the risk. Strong insurance companies such as the American International Group sold these. Investors snapped the securities due to this coverage. These are owned by everyone in time, including pension funds, big banks, hedge funds, and even individual investors. Bear Stearns, Citibank, and Lehman Brothers were some of the largest owners.A derivative supported by both real estate and insurance combinations was very profitable. As the demand for these derivatives grew, so did the demand for more and more mortgages from the banks to support the securities. Banks and mortgage brokers have given home loans to just about anyone to satisfy this request. Subprime mortgages were sold by banks because they made so much money from derivatives rather than the loans themselves.

2. Subprime Mortgages- The Financial Institutions Reform, Reconstruction, and Compliance Act strengthened the Community Reinvestment Act's compliance in 1989. This Act sought to eliminate poor neighborhoods ' bank "redlining." That practice had helped ghettos grow in the 1970s. Regulators have now ranked banks publicly as to how well they have "greenlined" neighborhoods. Fannie Mae and Freddie Mac reassured banks that these subprime loans would be securitized. That was the "pull" factor in addition to the CRA's "push" factor.

3. The Fed Raised Rates on Subprime Borrowers The new derivative products were accepted by banks hit hard by the 2001 recession. Alan Greenspan, Chairman of the Federal Reserve, reduced the fed funds rate to 1.75% in December 2001. The Fed reduced it down to 1.24 percent in November 2002. That also reduced adjustable-rate mortgage interest rates. The payments were lower because their interest rates were based on the yields of short-term Treasury bills and on the price of fed funds. This, however, reduced the profits of the banks, which is dependent on interest rates on loans.

Many homeowners who were unable to afford traditional mortgages were delighted to receive approval for these interest-only loans. As a result, between 2001 and 2006, the proportion of subprime loans doubled from 10% to 20% of all mortgages. It had grown into an industry of $1.3 trillion by 2007. The emergence of mortgage-backed securities and the secondary market put an end to the recession of 2001. It also developed a property bubble in 2005. Demand for mortgages has driven up housing demand that homebuilders have been trying to meet. Many people bought homes as investments to sell as prices continued to rise with such cheap loans.