Lehman Brothers

Topics: Subprime mortgage crisis, Financial crisis of 2007–2010, Financialization Pages: 30 (5550 words) Published: November 3, 2013
Part A:
1. Introduction
The Financial Crisis of 2007-2010 is often cited as the most significant downturn in the economy since the Great Depression of the 1930s. It erupted on August 9, 2007 and spread throughout the advanced market economies such as the US and the UK.

The Financial crisis of 2007 is notably different from other crises we faced, for instance Anthony Herbst and Joseph Wu (2009) argued that ‘the financial crisis of this first decade of the 3rd millennium has features that make it both severe and somewhat intractable’. The crisis is argued to be not exogenous to our capitalist economic system, since it is intimately connected to financial innovation and de-regulation in financial markets. Furthermore, as Herbst and Wu (2009) advocate, ‘the current pandemic’ should be discussed in the light of ‘the political wrapper surrounding many aspects of it, and the threads running through it’. The economic situation and financial behaviour are always affected by political realm, so it is also necessary to consider political factors in evaluation of the crisis.

General causes of this crisis are still being debated in the academic literature, and this paper aims to provide a relatively comprehensive outlook on the most common and empirically successful accounts of factors that contributed to the crisis. This report is organised as follows: part 1 provides a brief introduction to the current financial crisis; part 2 briefly evaluates the possible causes; part 3 examines whether insufficient regulation was the primary reason to all other listed causes of the crises and thus can be regarded as the primary cause of the recent collapse; part 4 concludes. Even though lax regulation has contributed significantly to the origination and development of the crisis, by examining other possible causes I explicitly argue that it is the interplay of different factors that shaped the crisis in the form we faced it in 2007.

2. Causes of the crisis.

Academic research has advanced a great number of explanations to the severe financial downturn and economic distress of 2007. The U.S. Financial Inquiry Commission has outlined the number of causes, which are summarised by Mark Jickling (2010) - see table 1 in the appendix. It should be 1

 

 

noted that, as with any complex phenomenon, the causes of the recent financial distress are not independent but instead linked to each other, for instance Credit Default Swaps (CDS) were direct outcome of financial innovation, and their excessive spread was mostly motivated by short-term incentives.

We will now discuss some of the most often cited in the literature causes of the crisis, which in my own opinion are also most influential: housing bubble, inappropriate risk management and the rise of financial innovation and subprime lending. We will consider financial deregulation the last as I argue that it underpins all of the reasons mentioned above.

2.1. Housing bubble
Home prices are normally pushed by the increased demand for housing. However, as I show later, in the current financial crisis most of the pressure on house prices also came from growing appetite of investor to reap high yields from their MBS and CDO investments. In the housing bubble, the growth of house prices far exceeded the rise in income of citizens. The most dramatic result is probably that over the decade ending in 2006, the price of the typical American house increased 124%.1 At the peak of the bubble in 2006, the national median home price was 4.6 times the median household income. 2

Homeowners also contributed in a significant way to the crisis by taking out second mortgages or home equity loans, thus increasing their leveraged paper wealth. In line with current accounts imbalances theory (see Roubini, 2007 or ...), for the period of 2000 - 2007 the growth in the flow of foreign money into the US economy outpaced the growth in supply of relatively safe assets to invest it in. By 2003, the supply of...
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