What Was the Main Cause of the Financial Crisis in 2007-2009?

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The intention of this essay is to provide an in depth and critical analysis of the financial crisis that took place between 2007-2009, in particular focusing on some key issues raised by the Foote, Gerardi and Willen paper ‘Why did so many people make so many Ex Post bad decisions?’ Whilst there were many contributing factors, it is clear that a specific few played a particularly dominant role, primarily the ‘Bubble Theory’, irresponsible regulation, toxic CDO’s and $62 trillion of CDS’s.

‘That’s what bubbles are: they’re examples of mass delusions’ (Norcera, 2011). Bubble theory’s are by no means a new school of thought, in fact they date back to the Dutch Tulip bubble in the 1630’s and it is these types of bubble that are believed, by many economists, to be the primary cause of the foreclosure crisis. The bubble theory explains the crisis as a natural progression of overly optimistic price expectations for a particular asset class, recently the US housing market. When the housing bubble began to enlarge, lenders were lulled into a false sense of security, which lead to large amounts of credit being extended to ‘sub prime’ borrowers, people who had shady or uncertified credit history. However due to the inflating house prices the banks seemed to have little concern towards the credit being repaid. Although this credit was issued to subprime borrowers through the securitised credit market, securitisation was not necessarily the definitive cause of the crisis, but what it did was act as a catalyst allowing borrowers and investors to undertake their desired transactions. With this appetite for risk from lenders and interest rates being cut to 1% by the Fed, institutional investors were eager to chase higher returns. The opportunity encouraged investment banks to anti up their leverage and create a higher yielding product which was directly linked to an ‘ever rising housing market’.

The emergence of Special Purpose Vehicles (SPV’s) allowed banks to over leverage and buy mortgages which were then bundled together into a special purpose vehicle, proportions of these were then subsequently sold off as a Collateralised Debt obligations (CDO’s), ‘an investment-grade security backed by a pool of bonds, loans and other assets’. The theory behind this SPV was to reduce the lenders liability by pooling hundreds of supposedly independent mortgages, meaning that in the event of any mortgage defaults the loss would be contained rather than having a simultaneous effect on the other mortgages pooled within the CDO. Given that house prices were expected to continue along the bubble’s growth path, any losses from mortgage defaults would be naturally offset by house price inflation, or so they thought. Once the Investment banks had packaged these mortgages they then sought to diversify their liability by selling off the mutual funds to external investors, some more bullish than others and hence the segregation of tranches within the CDO packages. The riskiness of each tranche was determined by the rating agencies, Standard and Poor/Fitch, which ranged from AAA (the lowest risk, but highest price) to CCC (the highest risk, but lowest price). In the event of any mortgage defaults, the highest rated tranche, the senior tranche, was paid out first and any subsequent losses were absorbed by the junior tranches, ie junior tranches were only paid once the other tranches had been paid. Given that the Fed had cut interest rates to 1%, the opportunity proposed by these CDO’s became increasingly more attractive. The excessive demand chasing CDO’s forced banks to lower their credit requirement standard, which inevitably lead to subprime lending. This access to the credit markets for those who ordinarily would have been declined credit meant that CDO’s were becoming filled with comparatively high risk mortgages. This became increasingly problematic when borrowers began to default on their mortgage payments, the domino effect lead to the collapse of...
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