Financial Crisis of 2007-2009 Essay

Excerpt from Essay :

Financial Crisis and Its Implications: Events Occurring Between 2007 and 2009

A Critical Literature Review

The Roots of the Crisis

Real Estate Valuation Bubble

Sub-Prime Mortgages

Low Interest Rates

Moral Hazard in Regard to Consumer Spending

Packaging Real Estate Loans as a Commodity (Derivatives)

Market Interrelatedness

Future Implications

The financial crisis, which seemed to be elevated to its greatest extent world-wide between the years 2007 and 2009, is difficult to unravel. The causes, interlink-ages, and effects are so intertwined that it is hard to separate them into a "first cause" or anything else that would resemble a succinct explanation. Although in retrospect, many individual underlying themes are attributed to the underpinnings of the crisis; in reality there are a plethora of variables that must be accounted for in trying to determine the crisis's root cause. Additionally, none of these factors can be considered in a vacuum. That is, none of the factors that are relevant acted independently. Instead, the variables all intermingled in real-time to expedite the adversities that fell across the board in all industries and in nearly all countries.

Though many attribute the crisis's origins to the United States which consequently infected the world-wide economy with the seeds of the crisis, the blame cannot be solely pinned on U.S. investors. If the world-wide economies were not so entangled then the U.S.'s bubble burst would have been constrained to that country alone. In this research paper we will examine some of the fundamental errors that are responsible for the existence of the bubble which set the crisis in motion. However, we will also examine some of the interdependencies that exist that fueled the explosion of the crisis into different continents. Again in retrospect, if various economies would have been prone to effective risk aversion, then many of the global effects could have been minimized.

The Roots of the Crisis

The roots of the crisis can be, with hindsight, be attributed to several causes. One of the most fundamental causes can be attributed to the dismantling of the Glass-Steagall Act. This momentous deregulation of the banking industry began when the president Clinton era passed regulations that revolutionized the way banks do business (Lal 2010). The bailouts that occurred in the U.S. In the 1970s are no longer an exception to the normal operations of the economy; now they are approaching the norm. Taxpayers are now exposed to covering the enormous risks that speculative banks incur as a result of their investing activities.

Therefore, if banking establishments are truly "too big to fail" then where does the incentive lie to invest in risk diverse portfolios? More specifically, if a bank grows to be so large that an entire economy is dependent upon it then where lies the advantage of competition as Adam Smith might of envisioned it. Surely no risk adverse institutions would endeavor in such illicit practices; however nearly all of the mainstream primary financial institutions fell victim to the downturn to some extent; obviously, some more than others.

Thus, it comes to question whether the adverse effects of the financial downturn were a mere fluke or something more systemic. If a fluke, then the world will recover in a matter of a few business cycles. However, if the downturn represents a flaw in the capitalistic system then more of an overhaul may be necessary to correct the injustices present in the current practiced version of capitalism. For example, it may be in the best interest of all those involved to regulate markets to a greater extent. Deregulation certainly seems to preclude the detrimental occurrences, as exhibited in the fall of the tenure of the Glass Steagall Act.

Real Estate Valuation Bubble

One principle cause of the recession, by most researchers' standards, is that the real estate market in the United States was propped up by unsubstantiated valuations in terms of appraised value. The "housing bubble" in terms of valuation had grown to a level in which the actual asset price exceeded that would have been otherwise deemed as normal due to inflated demand as a consequence of lower interest rates. The buyers' power due to the availability of low cost loans made the speculative real estate investment market open to those who were subsequently unable to secure finance. This situation created a market place in which buyers could purchase a mortgage with no initial investment on their behalf (Zhang 2008).

This opened the flood gates to new loan originations for buyers that were previously unable to participate in such activities. This in turn, drove the value of homes skyward due to the fact there was a substantial increase in demand. Competition for the ownership of housing was at an all-time high. Consequently, the value of property reached levels that were previously unimaginable.

Sub-Prime Mortgages

In the new market place, a new form of loan originated. This was referred to as sub-prime mortgages. A sub-prime mortgage entailed lending to an individual whose ability to repay the debt was somewhat questionable and therefore was coined as sub-prime. Since the ability to repay among these consumers was not at optimal levels, this represented a very risky category of borrowers.

When the downturn began its course, this category, since it was already on the threshold of insolvency, represented the kindling that fanned the flames of the fire (Fratianni and Marchionne 2009). These consumers, unable to meet their obligations satisfactorily, brought on a wave of foreclosures that reached levels that were unknown since the time of the great depression. The "American Dream" of homeownership had backfired and was causing banking establishments to acquire massive loads of debt that would otherwise be listed on their balance sheets as an asset.

Since the markets were so intertwined, once the effects of the sub-prime market began to be felt, the implications spread throughout the global economy nearly instantaneously. Furthermore, the value of real estate in the United States tumbled rapidly thus causing many people who were in the sub-prime category to owe more on their mortgage than the present market value of their property. Thus the situation created an instance in which it was actually beneficial for them to walk away from the property as opposed to honoring the agreements set forth in their loans.

Low Interest Rates

Further tracing back of the financial crisis reveals that the only reason the sub-prime phenomenon was possible was because of low interest rates established by the Federal Reserve Bank in the U.S. The Fed kept interest rates artificially low as a policy intuitive to help stimulate the economy. The low interest rates thus provided an incentive for both consumers and banks alike to increase borrowing activities.

This provided the underpinnings that made the sub-prime market segment possible. Banks had to look for new customers to provide lending for in order to stay competitive amongst their peers (Asensio and Lang 2010). Therefore banks construed creative means by which consumers could borrow with no money down. This meant that borrows would not have to invest any of their own money in order to buy property. Since many individuals in this category could not afford the down payment anyway, this created a large consumer base that was borrowing on solely their inflated credit worthiness alone with no initial investment on their part.

Moral Hazard in Regard to Consumer Spending

Since consumers literally had none of their own money invested in such types of scenarios, it fostered the creation of relationships in which moral hazards were implicit. If it was more financially beneficial for a mortgage holder to walk away from their loan, as opposed to complying with the terms of the agreement, then they were more apt to do so than if they had made a significant investment of their own money. Since the prevalence of no money down lending had become mainstream in the sub-prime market, the instances of moral hazard were prevalent throughout the economy.

Thus once the real estate valuation bubble burst many homeowners found themselves in situations in which they owed more on their homes than the market price would allow for. Therefore it was not only reasonable to look for better options, it was actually in their best interest financially (Mayes 2009). This, in turn, created an environment that produced incentives for moral hazards across the board.

Packaging Real Estate Loans as a Commodity (Derivatives)

Another phenomenon that contributed to the financial crisis was the creation of a new and complex set of financial instruments known as derivatives. With the creation of these tools, what lenders could do is package loans for resale to various real estate funds. So when a bank created a mortgage, it only held it momentarily before selling it off to another lender. This also created moral hazard from the perspective of the lender since it was in their best interest to find creative ways to approve loans that they would otherwise not even consider. However, lenders knew that they would not be ultimately responsible to service the loan so whatever mistakes they…

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