The 2007-2008 Financial Crisis

The 2007-2008 financial crisis resulted in the collapse of financial institutions and markets, bailout by governments both in America and Europe. However, the most significant cause was the housing market. For example, it began with a burst in the housing sector with growth in mortgage default affecting the stability of financial market. It resulted in evictions, unemployment and foreclosure of most housing businesses. The effects spread to other economic sectors resulting in an overall decline in consumers’ wealth, and economic activities. Despite the effort to reverse the impact, incompatible fiscal policies worsened the situation described in this custom term paper.

Causes

The housing bubble was the first cause of the financial crisis. The U.S house prices rose significantly from late 1998 to 2005. It doubled over the time, more than the average wage. Additionally, the rise of the ratio of house prices to renting costs of 1999 also increased the housing bubble. For example, inflation adjusted house prices remained constant over the time hence escalating house prices and regional disparities. The increase in house prices reflected an increase in demand despite an increase in supply attributed to different factors (ILO 6).

The first factor was low interest rates from 1999 to 2004 making mortgage rates attractive to buyers. The cause of low interest rates was large current account deficits in the U.S, and trading countries such as China after the purchase of treasury bonds. As a result, central banks in respective countries channeled liquidity credit markets to ensure cash flow at low interest rates. Additionally, Chinese firms bought large amounts of securities from Western nations. The huge supply of debt facilitated a decrease in lending standards to meet the demand. Investors could borrow at zero interest rates and invest in other countries, such as New Zealand, and Australia, at a higher rate caused large outflow of funds from Japan, and which also led to the property bubble in globally Australia (ILO 13).

Another factor was the subprime market. During the time, it was easy to access cheap subprime mortgages. For example, the gap between the interest’s rates in subprime and prime markets fell significantly from approximately 3% in 2001, to 1.3% in 2007. A reason for lending subprime mortgages is that the U.S Department of Housing and Urban Development pressured government sponsored enterprises to lower the standard for low-income families and fosters a home-ownership society. The result was state deregulation, which repealed the Glass-Steagall Acts to allow banks to operate commercial and investment activities. The deregulation created a conflict of interest and encouraged profitable opportunities for banks to sell-off mortgage-backed securities. For example, in 2004, GSEs backed less that 10% of new mortgages since credit quality and maximum valued restricted Fannie and Freddie’s practices (Halm-Addo 2).

The lack of Fannie and Freddie’s lending practices posed a risk in the business. For example, mortgage lenders who previously sold supreme loans based on the practices could only sell directly to banks instead of brokers. The banks later bundled the loans into profitable securities. As a result, mortgage lenders were useful while offering risky loans at attractive prices since banks sold directly to consumers. Additionally, mortgage originators devised ‘teaser’ schemes with initial low-interest or free rates to attract buyers (Halm-Addo 6).

The increase in house prices led to property speculation. For example, in some markets, 10% to 15% of buyers speculated that the property prices would appreciate. In the U.S speculation was a result of comparatively generous forecasting rules unlike in the U.K where it was a result of personal bankruptcy. Thus, speculators believed that the asset bubble would not burst creating incentives for moral hazard to investors. For example, inventors reaped large gains since fiscal policies of increasing liquidation mitigated the losses. The above factors created a bubble in the housing markets, and by 2005, the value of subprime mortgages relative to the new mortgage was approximately 20% as opposed to 7% in 2001 (Halm-Addo 7).

In 2006, the number of factors led to the housing bubble burst. First, the average hourly wage in the U.S declined between 2002 and 2009 (Eichort et al. 4). Consequently, house prices could not rise since mortgages were affordable. Secondly, the growth in housing supply tracked prices rises. While prices could not support the decreasing pressure, once the market reduced excess supply courses led to a fall in prices. Interest rates rose, ARMs were not attractive hence eliminating subprime buyers from the market. For example, in 2006, the Mortgage Bankers Association reports that the value and number of subprime mortgages reduced by 30%. As a result, personal serving from the disposable income was below zero, and fewer households had no resources to match the debt (Halm-Addo 6).

Blame on the above developments was also on regulatory authorities who did not address the growing issue on the global financial system. During the time, regulatory authorities developed prudential standards for the global financial system. The aim was to design a shock-proof global financial system and general capital standard for internal banks. The standards applied to a range of prudent issues relating to banks supervisor, securities regulations and accounting, insurance and cooperate governance. Additionally, the institutional environment for international regulatory and financial stability issues strengthened after the stability Financial Forum of 1999. Despite the above initiatives, the process had limitations. For example, even though there was a general capital standard for banks, they did not apply to securitization institutions such as investment banks, insurance companies and hedge funds. Additionally, regulator in the US and Europe did not apply to the creation of investments enabling evasion of the base capital requirements. For example, both U.S and Europe regulators allowed financial institutions to lowers reserves through purchase of CDS contracts (Halm-Addo 8).

For example, the cause of the financial crisis was inadequate regulation in the stock's market. A significant factor was the securitization process. The securitization process begins with a household buying a mortgage from a lender, after which they agree on an interest rate; either fixed or variable, over a time. The long-term interest depends on credit history and score, and risk of default. In the second stage lender transferred the risk of a default by selling the mortgage to the bank. However, where default occurs the owner would still receive returns from acquired collateral. However, a number of such housing products as SDO-Squared baked by original securities were sold in a similar manner (Halm-Addo 5).

Given that 80% of subprime MBSs were AAA and 95% A, the securities were attractive for investments and marked as high-asset value on a firm balance sheet. Once rated banks grouped the investments as collateral, or parceled-off and purchased asset portfolio. However, investments purchased as pension were safe while hedge funds were risky for monitoring. As a result, selling such securities benefited the issuers by providing cheap portfolios hence removing risky assets from the balance sheet (Halm-Addo 7).

Effects

Swagel Philip reports that the U.S household lost an average of $5,800 as a result of a decline in the economic growth during the financial crisis. The programs were state undertaking as part of the Troubled Asset Relief Program to guarantee bank liability. Another significant loss was by governments due to interventional policies to mitigate effects of the crisis. Intervention programs then led to a decline in the housing market, stock values, and jobs in the general economy (Halm-Addo 5).

The first effect was government interventions to mitigate effects of the financial crisis. Government interventions aimed at stabilizing banks and other financial institutions. The intervention ranged from loans from the Federal Reserve to channeling of public funds into banks and Treasury bonds. The U.S used TARP to support different activities such as the purchase of stakes under the CPPs, bailout to several firms such as Citigroup, Bank of America, and automotive industry to boost securitization of new lending. Much of the grants were from Term Assets-Backed Security Loan Facility in collaboration with Public-Private investments Partnerships, which also aimed at reducing the number of foreclosures (Halm-Addo 14).

An additional intervention includes the U.S congress bailout bill after the Labor Department reported that the economy lost more than 150,000 jobs. The government countered the banking liquidity by lending money, coordinating a global central bank bailout, and lowering federal funds rates to 1%. However, the situation worsened such that a report on the LIBOR banking rates rose to 3.45% while Dow Jones plummeted 13% of the stocks (Censky).

The second most significant impact of the financial crisis was on the stock markets. During the subprime crisis, the U.S markets went up by 18 over 25 years since 1982. Various assets such as housing did well during the time. The reasons were that the asset boom gave investors’ confidence of high gains. However, all asset classes fell in 2008 resulting in the decline of the global stock market. For example, in 2008, the decline in the U.S stock market was 37%, 38% in South America, 43% in Japan, 51% in China, and 38% in Europe. During the pre-crisis period, emerging markets seemed not affected by the crisis; however, in the later stages, they got hit. Additionally, even the Arab world and Russia suffered a dramatic crisis of confidence (Censky).

Another result of the bubble bust is the rise of commodity prices. For example, the global oil prices rose from $50 to $146, between 2007 and 2008. The increase was a result of speculations leading to flow of money from over investments into the commodity market, scarcity of raw material. A significant increase in oil prices caused the consumer to have less disposable income, leading to economic pressure on the consumers of importing countries. Another example in the commodity markets is the rise of copper prices. The prices increased from about $2,000 per ton in the 1990 to $7,000 in 2008 (Halm-Addo 15).

During the time, there was a significant decline in wealth and businesses investments. For example, the collective U.S net worth declined by 25, and in November 2008 the S&P 500 declined by 45% in one year. Housing prices dropped by 20% while total home equity estimated at $13 trillion in 2006 dropped to $9 trillion in 2008. Retirement assets, which are the U.S second-largest household assets dropped by around 20% from $10 trillion in 2006 to $8 trillion in 2008. Additionally, saving and investments and pension assets lost an average of $8 trillion. Secondly, as a result of the housing bubble, homeowners withdrew a significant amount of equity, which could not be sustainable after the crisis. The withdrawals increased from $625 billion in 2001 to around $1,400 in 2005. As a result, the mortgage debt relative to GDP rose from an average of 45% from the late 1990’s to 73% during the crisis to reach $10 trillion.

Another effect was on the labor market. Inflow and outflow rates from unemployment are cyclical. For example, during economic recessions, the inflow rates increase as people become unemployed and the outflow rates decrease as the slowdown in the economy makes it hard for employed workers to find jobs. Various factors of the crisis affected the labor markets. For instance, the structure of the economy plays a significant role depending on the country. Countries with elaborate financial markets, such as the U.S and U.K, have a large amount of workers involved in finance, and, as a result, were hit first. Similarly, countries with well-established housing markets, manufacturing exports, and constructions faced significant challenges in the job markets (Halm-Addo 13).

Nonetheless, in 2007, rapid employment rates caused by the housing bubble slowed and by 2008, there was a significant decline in the world. For example, in the G20 countries, the employment rate fell from 2% to 1.2 annually between 2008 and 2009. Countries with well-established business systems, such as the U.S and U.K, were the first to experience a decline in employment rates. In other advanced economies, job losses occurred in the later stages of the crisis as a result of declining investors’ confidence and demand. Initially, the stability resulting from U.S sub-prime mortgages did not spill over to emerging and developing economies. However, the results of the crisis eventually affected the economies (Eichort et al. 7).

The financial crisis also caused emotional distress to a significant number of people. Psychological heath is significant because it affects countries’ human, economic and social capital; as a result, a positive mental state of the population leads to the increased productivity of the economy. The 2008 financial crisis resulted in decreases in wealth and employment rate in the overall economy. It increased the number of households in high debts, and repossession of houses and evictions. Therefore, the crisis increased social exclusion of vulnerable groups, low-income people in both developed and developing countries. Such vulnerable groups include single-parent's families, unemployed, migrants and the elderly. For example, unemployment contributes to depression and suicide, while young people may face mental challenges due to unemployment (WHO 8).

A Future Economic Crisis

The U.S dollar experiences inflation every four to six years, which also affects other major currencies. Even though the word economy may be performing, the average household is not. Unemployment and household debts are high. Additionally, the GDP of most western economies is flat. The U.S economy will stagnate while unemployment rate remains at 8%. However, for the average household, a recession and recovery will appear the same. Additionally, after the 2008 financial crisis banks took a while before lending significant amounts of money. The reason is that they were worried that the situation would reverse (Halm-Addo 10). Additionally, people were also reluctant to borrow. The reason is that they borrowed enormous amounts during the housing bubble. As a result, even though the government developed fiscal policies to prevent a future occurrence of another crisis, a reduction in borrowing and increased debts in the economy may result in price speculation (Wilson).

An important determinant is how central banks and governments mitigate economic downturns. For example, as mentioned earlier, the most significant cause of the financial crisis was poor incentives in the mortgage industry. As the crisis develops, there are other factors that increase from the initial cause. However, the government developed policies to regulate the system. As a result of stimulus plans in 2009 there was confidence, and both consumer and firms started to borrow. Therefore, there may be a boom in the market resulting from the confidence. Consequently, oil prices will rise as in 2010 leading to the price increase in the commodity market. A significant boom will occur between 2015 and 2017 before another financial crisis in the early 2020’s (Halm-Addo 25).

As a result, the current debts will increase and governments will borrow money internationally. However, the approach is not new, and since 1900, a number of developed countries have huge government debts. Reducing the debts takes a long period, especially with the declining value of major world currencies. For example, due to the reasons, the IMF lowered growth estimates for the global economy to 3.6 in 2013 warning a future crisis. Yields on treasury inflation-protected securities indicate that deflation will lead to a decline on average prices between now and 2015 (Wilson).

Conclusion

The 2007-2008 financial crisis resulted in the collapse of financial institutions and markets, bailout by governments both in America and Europe caused by a bubble burst in the housing market. It resulted in evictions, unemployment and foreclosure of most housing businesses. The effects spread to other economic sectors resulting in an overall decline in consumers’ wealth and economic activities. The increase in house prices led to general speculation. For example, in the U.S, speculation was a result of comparatively generous forecasting rules unlike in the U.K, where it was a result of personal bankruptcy. Thus, speculators believed that the asset bubble would not burst creating incentives for moral hazard for investors. For example, inventors reaped large gains since fiscal policies of increasing liquidation mitigated the losses. Despites the effort to reverse the result incompatible fiscal policies worsened the situation. Even though the word economy may be performing, the average household is not. As a result of increased federal debts and incentives, the economy may experience a bubble in 2015 leading to a financial crisis in the early 2020’s.