Causes of the Financial Crisis of 2008-2009

Topics: Subprime mortgage crisis, Mortgage, Bond Pages: 5 (1729 words) Published: November 3, 2012
Causes of The Financial Crisis of 2007-2009

According to our financial textbook “ Financial crises are major disruptions in financial markets characterized by sharp declines in asset prices and firm failures” (Mishkin and Eakins 2012). In August 2007, defaults in mortgage market for subprime borrowers sent a shudder through the financial markets, leading to the worst U.S financial crisis since the Great Depression. Alan Greenspan, chairman of the Fed, described the financial crisis as a “once-in-a-century credit tsunami”. (Mishkin and Eakins 2012). Furthermore, Wall Street firms and commercial banks suffered losses mounting to billions of dollars. Households and businesses found they had to pay higher interest rates on their borrowings, and harder to obtain credit. World Stock markets, investment firms and banks went bell up. A recession began by December 2007. (Mishkin and Eakins 2012). The 2007-2009 Financial Crisis was caused by multiple interrelated causes including: subprime mortgages, unregulated mortgage originators, originate to distribute model which led to the securitization of loans, mortgage backed securities purchased by investors, and flawed credit ratings in behalf of credit rating agencies. The financial crisis was initiated by a bust and boom of mortgages due to low interest rates.. According to (New York Times 2011) The roots of the credit crisis stretched to another notable boom and bust: the tech bubble of the late 1990s. When the stock market declined in 2000, the Federal Reserve sharply lowered interest rates to limit economic damage. As a result, lower interest rates make mortgage payments cheaper and demand for homes began to rise, sending prices up. In addition millions of homeowners took advantage of the rate drop to refinance their existing mortgages. These created the quality of mortgages to go down. (New York Times 2011); With its easy money policies, the Federal Reserve allowed housing prices to raise to unsustainable levels (Jickling 2010). As a result of the Federal Reserve lowering interest rates and sudsidizing the housing market, the supply and demand for subprime lending and mortgage backed securities increased dramatically (Banking Law Committee 2009). According to Jickling (2010) it is difficult to identify a bubble until it bursts, and the Fed actions to suppress the bubble did more damage to the economy than waiting and responding to the effects of the bubble bursting. One of the most important factors, which caused the Financial Crisis in 2007-2009, is the subprime mortgages or subprime lending. “ Many Loans were made to borrowers with subprime credit or without appropriate credit analysis or documentation to support the loan (Banking Law Committee 2009). Furthermore, mortgage loans were made to borrowers for the first-time purchases. Some of these mortgages were structured so that they would require financing after a few years and could not realistically be repaid (Banking Law Committee 2009). The ability to refinance loans, incentivized households to borrow money from the bank they could not necessarily afford, hence most defaulted on their loans.

Moreover, a third factor which caused the Financial Crisis is unregulated mortgage originators. The mortgage brokers that originated the loans often did not make a strong effort to evaluate whether the borrower could pay off the loan, since they would quickly sell off the loans to investors in the form of a security, which is called securitization. (Mishkin and Eakins 2012). This particular scenario will be discussed further in the paper, where securitization of mortgages will be discussed. The mortgage companies that originated subprime loans operated free of federal oversight and engaged in practices generally not permitted for federally regulated lenders. For these originators, little was done to prevent abusive or unsound lending practices (Bank Law Committee 2009). Many banks bought loans from unregulated...
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