The 2007 US Financial Crisis Causes

Introduction

This paper focuses on explaining the underlying causes, effects and policy response to the 2007 financial crisis. There is an increasing volume of literature on the subject matter. This paper will attempt to overcome the lopsided and idiosyncratic explanation of the crisis, which attributes it almost entirely on the subprime mortgage (Simpson 6; Verick and Islam 3; Acharya and Mathew 2). The paper will also attempt to go beyond conformist version, which depicts the crisis as a financial crisis and not an economic crisis. This point of view was supported by the earlier administrations (Verick and Islam 3).

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On the contrary, this paper will try to understand the causes of the 2007 financial crisis from a broad perspective, specifically in terms of common structures and processes. The methodology used will be based on the procedural recommendation for analysing crises, that is, both the principal causes and the characteristic elements of the crisis must be justified. Based on the recommendation, the paper will also explore the link between different causes of the crisis (Acharya and Mathew 2). The paper draws on key elements highlighted by Verick and Islam, which ignores the role of global imbalance, but explains the significance of the interest rates and the US regulatory systems on the crisis.

Given the fact that new literatures are still emerging as regards 2007 financial crisis and that a comprehensive version is yet to be made, this paper to some extent will be provisional. However, it will systematically attempt to explain and relate the fundamental factors that led to the crisis, based on the analysis and synthesis of the existing body of literature. The argument here is that there were numerous factors that were involved in the crisis than those documented. They include global imbalance, low levels of interest rates, risk perceptions, government regulatory systems and sub-prime mortgage.

Causes of the 2007 crisis

Drawing from numerous literatures related to the 2007 financial crisis, four interconnected causes can be identified, namely: interest rates, global inequities, risk perceptions and financial regulatory systems in place (Simpson 4; Verick and Islam 5; Acharya and Mathew 2). Following the “dot.com” recession of 2001, the US banks and other financial institutions aggressively reduced the interest rates to extraordinary levels and, therefore, promoted loan-financed consumption that ultimately affected the global aggregate demand. In 2003, the interest rates in the U.S reduced to one percent. This helped to avert the “dot.com” recession temporarily, but oddly enough propagated the seeds of the 2007 financial crisis (Verick and Inayatul 15).

Simpson explains that decade before the crisis the US monetary policy was awfully loose leading to interest rates that were extremely lower than the conventional standard, which is based on the Taylor’s principle on interest rates. Taylor’s principle is a monetary rule that regulates the level of interest rates bearing in mind the prevailing economic conditions. As a matter of fact, it represented the biggest deviation in the last four decades. Indeed, the real funds were negative from 2002 to 2005 (3).

By emphasizing on trivial effects of price stability, the US financial policies failed to regulate the bubble in the real estate sector (Acharya and Richardson 5). At the same time, Verick and Islam point out that the boom in the housing sector began way before the millennium and, therefore, predates the low interest rate period, but concedes that slack financial policies contributed to the ballooning bubble in the real estate sector (7).

Acharya and Mathew attribute the low interest rates to the Middle East oil exporters and the Asian giants who developed an abnormal appetite for expanding foreign reserves in assets that were denominated in US dollar, for instance, treasury bills. This led to the so called “global imbalance”. The deficit economies were excessively spending, whereas the surplus economies were saving (15). The supporters of the global imbalance theory argued that such discrepancies were untenable and would have caused a major financial crisis, even if the Great Recession did not implode (Simpson 66).

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According to Simpson, the low interest rates and higher returns on government bonds in the US encouraged risky behaviour among the investors. The investors began to search for higher-yielding assets, hence the high demand for mortgage finance. Banks and other financial institutions exploited the low interest rates to expand their products. Having exhausted the credit-worthy clients, the American Banks and other financial institutions resorted to riskier market segments. The emergence of new financial products beyond the range of prevailing laws proved to be a key regulatory failure (56).

Verick and Islam attribute the risky behaviour by banks and financial institutions to slack regulation of the financial systems, which dates back to the 90s and culminated in the late 90s when the Gramm-Leach-Bilely Act was ratified. The Act reversed the restrictions posed on financial institutions by the Glass-Steagal law of 1930s. Besides lax regulation, high-risk loans were encouraged by the political class who were advocating for affordable housing for the poor and disadvantaged (18).

Effects and the Government Response

In 2006, the Breton Wood institutions expressed their concern over the delicateness of numerous security products provided by the US financial institutions. They felt that the borrowers were not taking the negative aspects of such products with the seriousness it deserves. The principal concern was the sharp decline in the prices of houses since securitization was based on supposition that any difficulty faced by the investors would be offset by growing property market.

However, in the fourth quarter of the 2007 it was obvious that the property market was also declining sharply. As the value of property was plunging and the rate of defaulters increasing, the asset backed-securities attached to the US housing sector began to devalue at a higher rate than was anticipated (International Monetary Fund 5). The drop in the value of residential property took away the incentive to pay back the mortgage, thus increasing the rate of the defaulters.

The slump in the US property market robbed the global financial market of two important components namely: confidence and trust. The financial institutions were exposed and had to suck up massive losses, though it was not clear which bank was most affected. The uncertainty increased mistrust among the financial institutions, forcing them to stop lending funds to each other as they were unaware of each other’s financial statement (Marshall 22).

As the banks and other financial institutions tried to switch and minimize risks, their readiness and capability to give credit was held back, hence tightening of fiscal and monetary policies. The availability of liquid assets in the global monetary market worsened in the 3rd quarter of 2008 when major financial and insurance institutions collapsed. The fall of Lehman Brother totally destroyed confidence in the monetary market (Simpson 70; International Monetary Fund 6).

The crisis prompted the Troubled assets Recovery Plan and the Economic Stabilization act of 2008 (Marshall 30). At first, the US government responded to the crisis by authorising the Treasury Secretary to acquire and sell troubled assets. The government released 700 billion dollars to that effect. The measure was aimed at minimising the losses made by financial institutions and thaw out the credit market. The purchases comprised of outstanding and commercial mortgage-related assets, which included mortgage backed securities and loans. In addition, the fund was used to bail out a number of industries that were hard hit by the crisis, for instance, the US automobile industry (Marshall 31).

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The Economic Stabilization Act of 2008 gave the treasury department power to establish mechanisms for acquiring and trading troubled assets, as well as getting hold of shares in banks and other institutions using market instruments. The legislation authorized the treasury secretary to direct and monitor all the fiscal and monitory activities of the foreign and domestic banks. It also prohibited profiting from the sale of troubled assets, and establishments of two financial oversight bodies. In addition, the law barred excessive risk-taking and golden parachute payments (Marshall 35).

Conclusion

The 2007 financial crisis was the most profound and extensive financial slump ever experienced in the recent times. The crisis was mainly attributed to the US subprime market. Even though reports on sub-prime crisis became public as early as 2007, its impact was not felt immediately. The impact of recession was very devastating, especially in the property market. It caused the asset backed-securities attached to the US housing sector to devalue at a higher rate. The drop in the value of residential property took away the incentive to pay back the mortgage, thus increasing the rate of defaulters. Subsequently, a number of banks and other financial institutions collapsed. This prompted the Troubled Assets Recovery Plan and the Economic Stabilization act of 2008. These were aimed at minimising the losses made by financial institutions and thaw out the credit market.

Works Cited

Acharya, Viral and Mathew Richardson. “Causes of the financial crisis”. Critical Review 21.2 (2010): 2-33. Print.

International Monetary Fund. Global Financial Stability Report: Financial Stress and Deleveraging, Macro-Financial Implications and Policy, Washington, DC: IMF Multimedia Services Division, 2008. Print.

Marshall, John. “The financial crisis in the US: key events, causes and responses”. Research Paper 09/34.

The Economist. The origins of the financial crisis: crash course. Web.

Simpson, David. Recession: Causes and Cures, London, UK: Adam Smith Institute, 2009. Print.

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Verick, Sher and Inayatul Islam. The Great Recession of 2008-2009: Causes, Consequences and Policy Responses, Canberra, Australia: International Labour Office, 2010. Print.

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