Question

The financial crisis of 2007–2009 was the most severe one since the Great Depression of the 1930s. What were the main causes of the 2007–2009 financial crisis other than the housing market collapse? What were its impacts on the U.S. financial institutions and markets? If you were an economic policy decision maker, what could you have done better to resolve the financial crisis during that period.

Answer 1

Other than the collapse of the housing sector, the major reasons for the financial crisis were the Federal Reserve's expansionary policy which causes lower interest rates in the market. The banks were providing the sub-prime loans to the customers who were not eligible for the loans. Also, the other reasons include over securitization of the home loans provided by the banks. The banks securitized the home loans taken by the retail customers and sold these loans to other financial representatives which further issued Mortgage-backed securities (MBS) and Collateralized Debt Obligations (CDO) to the investors and investment banks.

Another major reason behind the crisis was the failure of the Credit Rating Agencies. These agencies issued high credit ratings to the MBS and CDO which constitutes the pool of loans subjected to higher chances of credit default. These CDOs also purchased Credit Default Swaps (CDS) to safeguard themselves against any credit event. But with the collapse of the housing market, these CDSs were triggered but there were counterparty defaults on these CDSs.

As a policymaker, I would have introduced the following reforms:

1) Strict regulation over the issuance of home loans by the banks to avoid subprime loans.

2) Regulation of the over-the-counter markets over the sale of the Credit Default Swaps.

3) Regulation of the securitization of the loans by the financial institutions.