Question

Hello:

Please explain one major global financial crisis that occurred after the year 2000. Please do not explain the U.S. Housing Crisis of 2007 or the Russian Crisis of 2014. I have a lot of information on these two crisis already. Please I have some information but not enough. Please explain the strengths and weaknesses and the root cause of this financial crisis.

Please list a reference for this financial crisis.

Thank you,

Judy M. Robinson

Answer 1

1. What triggered the 2008 financial crisis and how did it happen?

Primarily, it is believed that the deregulation of financial industries off late and somehow lax government policies were mainly responsible for setting the stage. What resulted was an explosion of complicated commercial activities that included derivatives and financialization of mortgages. The Federal Reserve of the United States was keeping the interest rates very low and this stimulated the demand for loans by individuals and corporations. Predatory investment banks and lenders extended a plethora of mortgages to numerous unqualified individuals. And this resulted in generating a vast pool of subprime loans.

2. How did deregulation and derivatives contribute to the financial crisis?

When the market began to collapse, a wave of mortgage defaults began to erupt as many homeowners were not able to keep up with their monthly payments. Banks initiated foreclosures on those who fell far behind in their payments. Housing prices began to decline and new construction came to a halt crippling the construction industry.

Consumer spending slowed down depressing earnings in other sectors. Banks became reluctant to extend new loans leading to a credit freeze that deprived qualified borrowers and investors of much needed capital. Unemployment doubled that was unseen since the Great Depression and millions of people simply dropped out of the labour market. Manufacturing was particularly hard hit and the automobile companies found themselves on the verge of bankruptcy.

3. What happened in 2003 when demand for mortgage-backed securities began outstripping supply?

Housing prices rose much faster.

4. Who is to blame for the financial crisis?

The case with adverse selection and moral hazard becomes obvious to this end. When the selection becomes the opposite or adverse, the economic activity gets distorted. The problem of adverse selection arises when private information is held by either the buyer or the seller. In case of insurance policy, insurance companies had no clue of the potential default done by the buyer of the policy. This is what happened to AIG

The finance department of AIG was selling Credit-Default-Swap or CDS to bond investors in mortgage-backed securities wherein billions of dollars were put at a risk of default. Because the home owners were taking loans in a greed of buying a home and instantly selling it a higher price, they were potentially ready for default. This private information was not available to AIG. When the US housing market crashed in 2008, these CDS failed and incurred huge losses to bond investors who turn to AIG asking to return their invested money. Eventually AIG went bankrupt and the government had to finally bail it out.

To prevent the mortgage market from collapsing, credit default swap acted like an insurance policy that promised the holder of the securitized mortgage in case of a failure of payment by the borrower. The presence of such apparently robust protective policies consolidated investors’ trust in the mortgage market and kept the bubble going. These insurance policies were not regulated and hence they only added to the problems of already fragile market.

5. What actions were taken beginning October 2008 to end the crisis?

During the financial crisis, the Fed officials were quick in action to encourage commercial banks to borrow from the Fed, primarily by announcing that the discount window was available to meet their liquidity needs and secondly by reducing the primary credit rate and finally by introducing the TAF.

The Fed was willing to provide credit and loans so as to avoid the bankruptcy of financial institutions that had the potential of a systemic risk. Although the Fed was pragmatic enough to avoid the bankruptcy of Lehman Brothers, its officials decided not to advance a loan to refrain Lehman Brothers from falling. Lehman’s bankruptcy in a way, worsened the financial crisis.

During the entire period the Fed attempted to alleviate the credit market strains by supplying continuous liquidity to all the affected firms so as to restart the frozen markets and reduce the risky lending rates.