Question

Explain the 2008-2009 Financial Crisis. List and explain factors that contributed to this crisis.

Answer 1

The financial crisis was caused primarily by financial industry deregulation. That allowed banks to engage in derivatives hedge fund trading. Banks then requested more mortgages to support these derivatives ' profitable sale. They created interest-only loans that made subprime borrowers affordable. Throughout 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.

The new derivative products were welcomed by banks hit hard by the 2001 recession. In December 2001, Alan Greenspan, Chairman of the Federal Reserve, reduced the fed funds rate to 1.75%. In November 2002, the Fed again lowered it to 1.24 percent. 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. Nevertheless, which lowered the incomes of banks, based on interest rates on loans.

Many homeowners who were unable to afford conventional mortgages were pleased to receive approval for these interest-only loans. As a result, the proportion of subprime loans tripled from 10% to 20% of all mortgages between 2001 and 2006. By 2007, it had expanded into an industry of $1.3 trillion. The creation of mortgage-backed securities and the secondary market put an end to the recession of 2001. It also created 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 assets to sell as prices continued to rise with such cheap loans.

Many of those with adjustable rate loans did not realize that in three to five years the rates would be reset. The Fed began to raise rates in 2004. The fed funds rate was 2.25% by the end of the year. It was 4.25% by the end of 2005. The average was 5.25% by June 2006. Despite premiums that they couldn't afford, homeowners were struck. Those prices rose much more quickly than previous rates of fed funds.Housing prices began to fall after reaching a peak in October 2005. In July 2007, they had dropped in 4%. That was sufficient to prevent mortgage holders from selling homes on which they could no longer pay. For these new homeowners, the rate increase of the Fed could not have come at a worse time. The bubble on the housing market turned into a bust. That created the 2007 banking crisis that spread to Wall Street in 2008.