Question

I think that the financial crisis of 2008-2009 was mainly caused by deregulation in the financial industry. This allowed banks to participate in hedge fund trading with derivatives, and then demanded more mortgages to support the sale of these derivatives. Banks then created interest-only loans that only became affordable to subprime borrowers.

That being said, probability did play a part in whether or not people thought they would be able to make a profit by flipping their homes. Before the crisis, thousands of people took out loans larger than they could efford, hoping that they could flip the house for a profit or refinance the house at a lower rate. These people thought that it was probable that they would be able to make a profit through taking out these loans. In the short term, many people were able to make money this way, but in the long term, they did not consider the probability as to whether or not they would be able to make a profit in the future. Eventually, individuals and investors could no longer resell houses for a quick profit, because they did not consider the long term probability of being able to flip their homes.

I need to reply on this to discuss with different opinion.

Answer 1

There were a number of factors in addition to financial deregulation that escalated the crisis namely:

Risky investment decisions and lack of due diligence: The collateralization of low-quality assets was one of the major drivers of the crisis.

Under normal circumstances, financial institutions and banks have a rigorous policy of due diligence before advancing loans. The lax policy standards manifested themselves in approval of “no documentation” and “low documentation” loans, which did not require verification of a borrower’s income and assets, and even the borrowers with poor credit history were able to afford subprime loans.

This was done on the assumption that bad loans could always be sold out in the secondary market in the form of collateralized loans before they went bad. Hence the risk of default was to be borne by the buyer and the banks could avoid losses.

Poor economic assumptions and projections about the home and real estate prices were also responsible for the escalation of the crisis. It was believed that property/home prices would never decline rapidly or simultaneously. Hence underwriters operated under the erroneous assumption that the subprime mortgage-backed carried little to negligible risks.

In addition, on a different note, the energy crises(1970s)might have remotely resulted in oil nations accumulating massive reserves of so-called petrodollars which were then recycled back into the U.S. financial system.

In the absence of the reserves, the global demand and supply would have been in equilibrium and there would have been lesser deflationary pressures on the global economy.

This has been debated as one of the factors leading up to a recession due to reduced production and spending, and the accumulation of inventories. Therefore the financial institutions, in order to gain potential borrowers, and put the funds to better use, had relaxed their underwriting standards and this led to poor loan quality.

* With inputs from sources and reports.