The financial system has been crucial to the role of free enterprise. “Financial markets have come to supply non-financial corporations with mechanisms for managing their risks and for comparing and evaluating diverse investment opportunities in a highly complex global economy” (Cindin, 2008). “However, despite the lifetimes it took to build our financial institutions, bad luck and careless risk management have jeopardized careers and mortgaged these institutions’ futures”(Wallace, 2008). The nation is currently attempting to deal with the biggest financial crisis since the Great Depression. It is now imperative that a way be found which will re-regulate finance without undermining finance’s needed innovative capacity.
The origin of the financial crisis can be dated back to 2006. During that period in time, companies began buying trillions of dollars of complex financial products called ‘structured credit derivatives’. The value of these derivatives quickly escalated to over one-hundred trillion dollars due to the high demand from banks around the world. “These paper investments were supposedly backed by loans on houses, cars, businesses, and credit cards” (Francis, 2008). Nevertheless, several issues have erupted from the sale of these paper investments. The production and trading method for derivatives is unclear, and no one really knows what credit risk is transferred to whom. Basically, banks were fighting over assets with questionable values. Even though the sale of derivatives has disrupted our economy, it is not the primary reason for which the financial system is now in distress.
The reckless selling of mortgage loans has lead to the eventual breakdown of our financial institutions. “The US sub-prime mortgage market has been derailed by the reversal of the housing boom” (Stewart, 2008). This is the result of commercial and investment banks lending vast sums for housing purchases and consumer loans to borrowers who are ill-equipped to repay. As consumers begin to default on their loans, banks are realizing the horrendous fact that they have no tangible cash to carry out business procedures. These profound errors in risk management are taking disastrous tolls on the economy.
The U.S. economy is now facing four serious problems. The first problem is that consumers are cutting back on spending in an effort to try and repay their loans. “Presently, consumers and banks are trying to reduce the amount of money borrowed in relation to their assets or income, a process known as de-leveraging” (Francis, 2008). This will cause a recession since consumers make up seventy percent of all spending. The inventory of unsold homes is now large, so the demand for housing and construction will be low for several years. Other businesses will also begin to reduce the production of goods in order to keep pace with the decrease in demand. The International Monetary fund is forecasting the United States’ gross domestic product to grow by just .5% in 2008 and .6% in 2009. The problem of consumer spending is actually the least of the economy’s worries.
The second dilemma that the economy faces is the increase in the number of defaults on mortgage payments and consumer loans. Large quantities of consumers were purchasing homes in belief that the property would increase in value. The consumers would then sell the homes at higher prices, therefore receiving a quick profit. However, house values began to fall below the mortgage values, resulting in defaults on loans. “House prices are expected to fall by up to a further ten percent before the downturn is over” (Stewart, 2008). This will be agonizing for millions of households, particularly the ones that borrowed heavily in recent years. Even though the consumers are suffering, banks are in even greater peril.
The third predicament facing our economy is the reduction in lending by the banking sector. The sharp cutback in lending...