Banking Crisis of 2007-2008, Its Actors and Causes

Introduction

The 2007/2008 global economic meltdown is considered one of the world’s worst financial crises after the great depression of the 1930s (Fligstein & Roehrkasse 2016; Jensen & Johannesen 2017). It gained this reputation because it affected multiple aspects of economic performance not only in America but also in parts of the world that were deemed unrelated (Fligstein & Roehrkasse 2016; Jensen & Johannesen 2017). More interestingly, it occurred after both the Federal Reserve and The United States (US) Treasury department put up a spirited fight to prevent its occurrence. The crisis initially started in 2006 when housing prices started to decline. Some people thought it was a good sign for the real estate sector because they believed it signified the onset of normalcy in an industry, which was deemed to be overheating (Garcia-Appendini & Montoriol-Garriga 2013). However, over the years, it morphed into a full-blown international banking crisis that included insurance firms, pension firms, hedge funds and other financial institutions that were not primarily based in the US.

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In 2008, Lehman Brothers collapsed as an aftermath of the crisis and it precipitated a global economic meltdown (Anand et al. 2013). The European debt crisis also closely followed this event and it prompted many people to question the future of the Euro and of the general European economy (Battaglia & Gallo 2017). According to the International Monetary Fund (IMF), major banks in the United Kingdom (UK) and the US lost “toxic” assets worth more than $1 trillion (Fligstein & Roehrkasse 2016; Jensen & Johannesen 2017). Some reports estimate that these losses could have reached $2.8 trillion (Anand et al. 2013).

Experts suggest that Americans lost up to 25% of their net worth during the crisis, while pundits say multiple economic indicators significantly underperformed during the period (Battaglia & Gallo 2017). For example, the S&P 500 was down by close to 45% and housing prices declined by more than 20% at the peak of the crisis (Saad 2015). Home equity in the US, which was valued at more than $13 trillion also significantly declined in value and dropped to levels lower than $8.8 trillion (Anand et al. 2013). The global economic meltdown also led to a significant decline in economic performance for many industries, with the real estate sector taking the hardest hit as house prices dipped by more than 31% (Saad 2015). Two years after the crisis, the economy was still reeling from its effects because unemployment was still high (at above 9%). During the crisis, there was also a $1.2 trillion decline in savings and investments as well as a $1.3 trillion loss in pension funds in the US (Battaglia & Gallo 2017). Collectively, experts estimate that the cumulative losses were about $8.3 trillion (Saad 2015).

Broadly, the banking crisis led to a significant decline in consumption patterns and a general underperformance of business investments. When these two aspects of economic performance overlapped with a decline in government spending, it was difficult to avoid a full-blown economic crisis. While the effects of the problem were open for all to see, it is still unclear who is responsible for the meltdown because many players were involved in the financial system at the time. Opinion regarding who takes the most responsibility is divided because some people assume regulators (authorities) are to blame for the crisis, while others say the banks are responsible for the same. This paper offers credence to the latter argument because it argues that the banks were to blame for the financial crisis because they exploited unregulated innovation by pursuing “greedy transactions” and financial practices that bordered on predatory business (lending to customers who they knew were unable to pay for their loans). Pieces of evidence supporting this argument appear below.

Predatory Lending

Banks were to blame for the 2007/2008 financial meltdown because they deliberately advanced credit to people who could not pay for their loans. Cabral (2013) defines this action as those befitting the intention of an unscrupulous lender who enticed borrowers to enter into financial transactions that were detrimental to their financial well-being. The primary motivation of the banks was to make a profit from the “poor” borrowers. Schoen (2017) says predatory lending was buoyed by a classic bait-and-switch method which premised on an insatiable need for lenders to offer would-be homeowners an opportunity to buy a house, which they would not have otherwise owned. Countrywide Financial, among other companies, practised this method of lending and sold several mortgages to “desperate” homeowners who would potentially “do anything” to own a home (Cabral 2013). Unknowing to them, these homes were secured by detailed contracts, which they knew nothing about and they were later sold or swapped for more expensive loan products (Schoen 2017).

The realtors had no idea how deep the problem was entrenched because they were unaware of the widespread nature of the crisis, especially based on the fact that some homeowners were taking credit on more than 100% of the value of their home purchases (Eneida & Blerta 2015). Although banks would initially indicate they charge a low interest rate of about 1%-1.5%, the same customers were subjected to a varying interest rate regime that sometimes forced them to pay interest rates that were greater than their mortgage payments (Schoen 2017). Such payments are ordinarily termed as “negative amortization” and they often went unnoticed until the entire mortgage was paid off (Eneida & Blerta 2015; Eneida & Blerta 2015). The depth of the rot in the financial system was revealed when Countrywide Financial sued the California Attorney general for engaging in wrongful and unethical business practices because their actions could be easily summed as false advertising (Schoen 2017). The claim was that banks were giving loans to homeowners with weak or poor credit histories, knowing that they would default. The banks would later profit from interest-only payments. When there was a decline in the house prices, at the height of the crisis, homeowners who were servicing their mortgages lost the incentive to do so because their home equities had disappeared. Some employees of one company called Ameriquest even admitted that they would often falsify mortgage documents and sell the securities to banks, which had a huge appetite for the assets because they wanted to sell them off and make huge profits from the transactions (Marshall 2013).

Based on the pieces of evidence alluded above, the predatory lending behaviour propagated by some banks led to the crisis because they lent money to creditors who would default on their payments, but they would still profit from the same transactions through complex financial instruments that will be discussed in subsequent sections of this paper. Their actions were not grounded on strong financial principles of fair practice and accountability; instead, they were partly motivated by greed and the quest to make a profit at all costs. Therefore, banks were the architects of the financial system that propagated predatory lending as envisaged in the works of Schoen (2017) and Marshall (2013). Stated differently, the actions of these banks lay the foundation for the crisis that was witnessed at the time. Another contribution of the banks (to the crisis) was their development of complex financial instruments.

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Complex Financial Instruments

There is little doubt among many researchers who investigated the 2007/2008 financial crisis that financial innovation was the primary root of the crisis. This view is held by researchers such as Diacon (2015) and Cabral (2013) who said that the development of sophisticated financial products largely complicated people’s understanding of the fundamentals that underpinned the global economic system at the time. Particularly, the development of collateralized debt obligations (CDO), mortgage-backed securities (MBS), and credit default swaps (CDS) formed an intricate and complicated web of financial products that affected the financial health of banks, insurance companies and real estate enterprises. Furthermore, it was difficult for financial experts to quantify or account for their effects on corporate performance in their financial books. For example, CDOs grew significantly before and at the height of the financial crisis from a low of $20 billion to a high of $180 billion (Schroth, Suarez & Taylor 2014). The predatory lending behaviour practised by some banks, prior to the crisis, also led to a significant decline in the quality of CDOs from 2000 to 2007 because subprime lending (which was equivalent to bad debt) accounted for up to 35% of the CDOs (Reddy, Nangia & Agrawal 2014).

The development of CDS by some innovative banks also worsened the crisis because it allowed them to allocate a theoretically infinite value of money on home loans. This outcome was feasible, so long as the buyers and sellers of the CDS could be identified. Many investors did not understand this fact and they bought CDOs and CDSs without the knowledge that they would be doubling their risks if there was a default in any one of them (Carolillo, Mastroberardino & Nigro 2013).

Through the use of complex financial instruments, a sophisticated financial system emerged and it was poorly understood by many investors. More importantly, it increased the number of actors in the mortgage and banking industries who did not understand the nature of financial transactions they were engaging in. This is because their investments put a long distance between them and the underlying assets. Furthermore, they relied a lot on third party information to make their financial decisions (Carolillo, Mastroberardino & Nigro 2013). Most of these additional players to the financial ecosystem comprised of mortgage brokers, auctioneers, credit rating firms, and trading desks (among others) (Krejčíř, Dostál & Doubravský 2014). Although the increase in the number of stakeholders was meant to spread business risks, it provided a lot of ground for the growth and spread of fraudulent financial transactions, such as the predatory lending behaviour discussed earlier. Coupled with several cases of financial misjudgments, a collapse of the financial system was imminent.

Based on the above analysis, banks played a key role in fanning the 2007/2008 financial crisis because they developed complex financial instruments that few people understood. They complicated the financial ecosystem by providing room for other players to venture into the sector, without a proper understanding of what they were doing or even how they would make money out of it. More importantly, the banks developed a faulty financial model that also had a similarly weak risk management framework. A calamity on one aspect of the model meant that all its other tenets would be affected. A domino effect ensued and eventually the entire system collapsed.

Unregulated Financial Innovation

The Community Reinvestment Act was considered one of the primary motivators for banking actions during the 2007 crisis because it allowed the institutions to invest in subprime mortgages (Baber 2013). However, as Armantier et al. (2015) report, this was not the underlying cause; instead, the Gramm-Rudman Act was considered the biggest catalyst of the problem because it provided the framework for banks to trade in profitable derivatives at the expense of the good health of the global economic system. The profitable derivatives were backed by mortgages and homes as collateral. Since the derivatives were profitable, the demand for more mortgages surged, creating the boom in the housing market, which later led to the financial crisis (Baber 2013).

Some experts say the Federal Reserve knew of the existence of such financial transactions but did not predict their ramifications for the entire economy because they believed it would only be confined to the housing market (Granter & Tischer 2014). They were wrong. Investors in different sectors of the financial market bought these “flimsy” assets and declared them in their company accounts as corporate assets. Others bought them as mutual funds, but their overall investment security was that they were mortgaged-backed (Granter & Tischer 2014).

The banks are to blame for the crisis because they segmented mortgages and sold them to investors in tranches. This action made it difficult to correctly understand the true price of the mortgage-backed derivatives as alluded through the work of Keen (2015). Through the actions of these financial institutions, some pension funds got involved in the scheme because they believed it was genuine. A post-crisis analysis of their actions shows that they bought the risky investments under the presumption that credit default swaps (which were to act as an insurance product) would protect them from any financial adversity. They were mistaken.

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AIG, which is an iconic American insurance company, sold these swaps, further strengthening the resolve of the pension funds to take part in the financial trade (Wójcik 2013). When the derivatives started to lose value, the insurance companies did not have enough cash to pay off their debt obligations. They later filed for bankruptcy. Consequently, banks realised that they would be the ones to absorb the losses associated with the derivatives and the credit default swaps, prompting them to stop lending money to one another (Carolillo, Mastroberardino & Nigro 2013). The motivation for doing so was to prevent the possibility of receiving worthless mortgages as collateral for the money they would lend out to their peers. Consequently, inter-bank borrowing costs increased and it led to a bigger threat to the economy when the banks could no longer lend money to one another. This market problem is deemed a significant catalyst of the financial crisis and banking actions are at the centre of it.

Conclusion

The genesis of the 2007 financial crisis has been unclear for most people. The involvement of many stakeholders in the system is largely responsible for the lack of clarity. However, through the evidence collected in this paper, banks emerge as the primary culprits in the development of the financial crisis. Nonetheless, one important lesson that emerges from the analysis of the 2007/2008 financial system breakdown is the role of innovation in guaranteeing the health of the global economic system. More importantly, the findings of this study show that financial innovation can fundamentally change the structure of the economic system and create far-reaching consequences that would not only be felt when the crisis is happening but also in the years after it ends. In the context of this analysis, the banks were at the forefront in championing for this financial innovation. Although they had the intention of making a profit, greed seems to have motivated their actions. The excessive risk-taking of some financial institutions, such as Lehman Brothers, helped to accentuate the effects of the financial crisis globally and led to a further spread of the crisis in other financial institutions that should not have been ideally affected by it. At the same time, the interconnected nature of the world’s financial system did not help in containing the problem because financial institutions around the world were affected by what seemingly was a small problem in the US subprime mortgage market. In other words, the interconnected nature of the financial system emerged as a framework that helped to disseminate the effects of the economic crisis in other parts of the world. However, banks were at the centre of the crisis and are to blame for it.

Reference List

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