Introduction
The 2007-8 financial crisis passes as the biggest economic meltdown since the great depression of 1929-30 that caused a decade long recession in the Western countries. Like the Great Depression, the 2007-8 meltdown spread like wildfire, from the United States to Europe and the United Arab Emirates, sweeping wealth accumulated after years of toil and causing emotional breakdown in millions of families (Helleiner, 2011), Even today, some analysts blame the crises in Europe – Spain, Italy, Cyprus and Greece – to the 2007-8 crisis, terming the situation as a hangover to the events of the 2007 crisis. The effects of the crisis were first felt in the US where iconic American families like Lehman Brothers went bankrupt and other multinational players like AIG (America International Group) and General Motors needed bailout from the government to avoid going out of business. AIG had been the world’s biggest insurer for years and it needed $85 billion bailout from the government to stay away from total collapse (Murphy, 2008). The government intervention to save companies like General Motors and AIG attracted a lot of criticism from common folks who did not receive any reprieve from the government despite suffering the biggest losses from the crisis. The idea of “Too Big to Fail” has attracted debate since the onset of the financial crisis with some schools opining that big corporations should not be bailed by the government (Murphy, 2008). For the first time since the 1930’s, the US economy grew at a negative rate forcing the government to implement a myriad of strategies known as quantitative easing that would trigger the economy to positive growth. This paper will discuss the causes of the 2007-8 economic crisis by using academic journals and industry publications followed by a review of the solutions that were applied by different governments before providing an evaluation of the solutions and their effect on the economy to determine whether the causes of the 2007-8 crisis were overcome.
Causes of the 2007-8 economic and financial crisis
Housing market and subprime mortgages
The US housing market is identified as the industry where the financial and economic crisis began through a mix of factors that played together to create unsustainable loans and housing prices. Before getting to the nitty-gritties of the economic crisis, it is important to understand the backdrop of the housing market through the American Dream (Callinicos, 2010). House ownership is regarded as a major economic step in the United States and many people do not pass a chance to take a mortgage to purchase a house. For a long time, owning a house was beyond the reach of many Americans due to the huge financial responsibilities and tough requirements that made it hard for people to purchase houses in the United States (Diamond, and Rajan, 2009). Owning a house is considered as the ultimate American Dream and it improves the social status of an individual. In an individualistic society like the US, the possession of a house improves self-concept and it offers promise of long-term stability for people who complete the process of buying a house.
The appetite for house ownership sits at the bottom of the factors that contributed to a series of activities that brought the economic crisis. In the 1990’s, the United States went through a process of deregulations hinged on concepts of neoliberalism. Neoliberalism is a political economy concept that holds that allowing markets to be controlled by forces of demand and supply is an act of giving autonomy to individuals. According to Harvey (2007) writing in the book “A Brief History of Neoliberalism”, framers of neoliberal policies support the idea of free markets by assuming that consumers are rational and that their behaviors are aimed at optimizing utility. Neoliberalism was viewed as an antidote to liberalism, and it was framed on the tenets of neoclassical economic theory that argues for small government (Coffee Jr, 2009). Again, the idea of small government imagines a situation where the government is not overly involved in the markets. Instead, governments should offer protection for private property as well as help in creation of markets in places where goods are not exchanged in a market situation.
The series of government interventions that reduced regulations in the 1980’s and 1990’s is captured by Sherman (2009) in a paper titled “A Short History of Financial Deregulation in the United States”. For example, the Fed reinterpreted the Glass-Steagall Act that prohibited banks from having share ownership in investment companies. The reinterpretation allowed banks to hold assets in investment banking in a way that allowed them to raise 25% of their revenues from these ventures. In another move that is seen as a landmark to the process of deregulation, Citigroup was allowed to merge with Travelers in 1998, a deal that involved combining a commercial bank with an insurance company which had an investment bank as one of its main assets (Sherman, 2009). In 1999, the Glass-Steagall Act was completely repealed, opening up a chance for banks to raise most of their revenues in from investment banking. The series of deregulation reached peak with the introduction of Commodity Futures Modernization Act that reduced the level of regulation on OTC derivative contracts such as Credit Default Swaps.
Deregulation of financial institution was part of a financialization process that was supported by neoliberalism whose aim was to give capital the power it once had before the introduction of Keynesian economics. The series of Acts that deregulated the financial sector in the 1990’s increased the influence of finance and owners of capital in the economy. It also allowed practitioners in the finance world to become creative and innovative. One of the most iconic innovations by financial players was the introduction of the subprime mortgages, a lending product that targeted low income home owners. Through subprime mortgages, people who had low credit rating would get loans to purchase houses (Seabrooke, 2010), The banks offering subprime mortgages could not give conventional credit to these borrowers because they did not meet criteria for conventional mortgage. To protect their interests, banks would charge a higher than normal rate to these customers in a bid to make more profits from subprime creditors.
The appetite for home ownership in the United States played a critical role in the innovation of subprime mortgages and the growth of their popularity. Between 1994 and 2003, the proportion of subprime mortgages to total mortgages in the United States oscillated between 8% to 10%. In 2004, the number of subprime mortgages rose sharply to represent 18% of the total mortgage origination before peaking at 20% in 2005 and 2006 (Hellwig, 2009). The onset of the financial crisis in 2007 saw a sharp collapse of the number of subprime mortgages that the banking industry was offering. The growth of the number of subprime mortgages in the United States was supported by several factors (Hellwig, 2009). Home buyers were not supposed to raise huge amounts of capital when buying a house. At the beginning of 2007, home buyers were only required to pay 3% of the total value of the house. This made it easy and tempting for low income people to purchase a house as they could bet on their future incomes to repay the mortgages.
The creation of subprime mortgages and the relaxation of underwriting policies created a huge demand for housing. Given that the number of houses available for selling could not keep pace with the number of people who had suddenly realized that they could afford a house, the price of houses rose in faith with forces of demand and supply (Coffee Jr, 2009). Many firms saw it as an opportunity as they would buy homes then sell them at higher prices within a short time. This housing craze moved in a cyclical way, attracting more home buyers who took subprime mortgages to buy homes. The spiral effect resulted into bloated housing prices that were financed by emotional buying supported by subprime mortgages.
Securitization
It only makes sense that top management in banks saw the growth in subprime mortgages in their balance sheets. The hindsight for many banking CEOs was that having huge loan books would limit the ability of the bank to lend more money in the form of a mortgage to customers. At the peak of the subprime mortgages, the proportion of subprime mortgages to total lending had reached 20% and the banks found a solution in MBS (mortgage backed securities) (Aalbers 2016). The concept of MBS was an innovative way for banks to pass on their mistakes to other players in the industry. The mortgages that had been issues to customers were repackaged and sold to investment banks and government agencies like Lehman Brothers and Freddie Mac or Freddie Mae.
Understanding the concept of MBS is important to comprehending the buildup of the financial crisis. In MBS, banks passed their risks on to investment companies and government agencies. Again, the issue of lax regulation came to play as banks could own investment companies, a factor that made it easy for them to find buyers for the mortgage backed securities (Acharya and Richardson, 2009). Investment companies like MBS and government agencies like Freddie Mae and Freddie Mac, as well as government-sponsored enterprises (GSEs) took up these securities and sold them to investors (Acharya and Richardson, 2009). So, the buyer of the security from an investment company would be holding an asset that is supported by a contract (mortgage) whose buyer is a person with a low credit rating, unstable income and a high chance of default.
Mortgage backed securities were not the only assets that were used to give banks a reprieve with regard to their ability to issue loans. CDOs (Collateralized Debt Obligations) were used to “sell” the cash flows expected from mortgages to investors. Just like MBS, CDOs were packaged as securities and sold to investors (Lucas, Goodman and Fabozz, 2008). CDO managers create a profile of different classes of CDOs by connecting them to the riskiness of the underlying assets (Mishkin, 2011). For instance, a CDO that is backed by conventional mortgage would be considered as senior, to mean that it is safe. That would convince investors buying the CDOs that they are not exposed to any risks in the market as they have money back guarantees through insurance policies.
The insurance industry got warped in the subprime lending market through the issuance of Credit Default Swaps (CDS). CDS offered insurance to CDO by taking the risk of default from the collateralized debt obligations. That way, investors buying CDOs were convinced that their assets were risk free because there were credit default swaps that would come to their rescues in case things went awry (Stulz, 2010). Looking back, it looks interesting how insurance companies offered the CDS product knowing that the assets that it was insuring were backed by weak assets in the form of subprime mortgages. Before the financial crisis, some investors – notably Paul Johnson and Mr. Murry – had warned that the market had gone crazy and bought puts (which were essentially bets against the market) in their hedge funds. However, they were ignored as pessimists who did not understand how the market worked.
Credit agencies
The creation of Mortgage Backed Securities and Collateralized Debt Obligations and their subsequent sale in the securities markets was influenced by credit agencies such as Moody’s, Standard & Poor’s as well as Flitch Ratings. Credit rating agencies usually give their evaluations on whether a security is safe for purchasing or whether investors should be wary of making losses due to excess exposure (White, 2010). Before the 2007-8 crisis, people had a lot of faith in credit agencies because they provided an opinion on the potential risk of securities (He, Qian and Strahan, 2011). A security that is rated AAA by Moody’s, for instance, shows that it has a very low risk of default. It means that investors who purchase these securities have low risk and they are assured of their returns.
Investment companies like Lehman Brothers and government agencies and government-sponsored enterprises bought MBS and CDOs following the guidance from credit agencies. In hindsight, agencies such as Moody’s and Standard & Poor’s knew that assets that were backing the mortgage and debt obligated securities were not fundamentally safe since they were based on flawed lending He, Qian and Strahan, 2011). For instance, Moody’s had found out that 43% of borrowers with sub-prime mortgages had not provided adequate details of their incomes. This meant that banks did not have enough information regarding borrowers who had taken mortgage loans and that spelled doom in the event that the banks decided to collect funds from these borrowers.
Further, the process of carrying out due diligence for individual investors is time consuming. It also requires access to primary data for investors to determine whether assets that they are buying have a strong backing or not. In the United States, the credit rating agencies were trusted to do the due diligence and analysis on behalf of investors. Thus, when they released the ratings giving most of the MBS and CDOs top ratings, people thought that the investments were safe. In their defense, credit rating agencies argue that they gave their ratings depending on the information that they had. For some people, the activities of credit agencies like Moody’s and Standard & Poor’s is a classic case of “who pays the piper calls the tune” because they make most of their income from companies issuing securities and bonds. They do not make a lot of money from fees paid by people (investors) who want to use the information to make decisions. Therefore, there is a possibility that the credit agencies were caught up in the madness and accepted to give generous ratings so as to earn more revenues in issuance fees.
Political goodwill
In an ideal situation, the political class would have acted as the last line of defense for American investors by making a move that would restrict the activities of banks. The government knew that subprime borrowers were staying in houses that they could not afford. The Department of Housing, for instance, gave agencies like Fannie and Freddie the go-ahead to buy MBS that were supported by subprime mortgages. Also, the government agencies relaxed the underwriting standards in the finance industry to give low income and lowly rated borrowers. The political class gave the housing industry support by asking government agencies to buy most of the subprime mortgages. The thought that assets were backed by the government increased the appetite for MBS and when Fannie and Freddie stopped buying the MBS, the whole industry came crumbling as people realized that they were excessively exposed. The political class was eager to encourage people to buy subprime mortgages for them to achieve the American dream. By doing so, they contributed to the relaxation of regulations and laws that exacerbated the financial situation and caused the financial crisis.
Government interventions in the crisis
Immediate responses
The onset of the financial crisis and its spreading to other sectors of the economy and other countries saw governments in the US and the UK implement a mix of strategies aimed at limiting the extent of the damage and preventing a future re-occurrence of the crisis. The United States government used $700 billion to bail out companies that were staring bankruptcy. The government rationale was that allowing such companies to fail would bring more damage as it would make people jobless and depress the economy further (Diamond, and Rajan, 2009). The UK government took similar decisions by bailing out Lloyds with funds worth £19 billion, RBS with £45, B&B with £18 billion and NR £26.9 billion. The president of the United States, Barack Obama, argued that the decisions of the government to bail out companes paid off, and despite spending $700 billion, the government had recovered its investment. The UK used more funds per capita to rescue businesses that had been affected by the financial crisis.
Other measures that were taken at the height of the crisis in 2008 in the UK include the temporary cut of VAT in the United Kingdom. It was designed to be a reprieve for the citizens by reducing the cost of a basket of food and putting people back on track to economic stability. The US had several fiscal strategies that were aimed to motivate the economy and bounce from negative growth. The America Economic Stimulus Act (2009) supported teh allocation of resources by having all workers get $300-600 per person. The move was aimed at helping people deal with the negative impact of the financial crisis that was damaging families and making people sink into financial distress.
In 2009, President of United States signed into law a bill called American Recovery and Reinvestment Act (2009) that hinged on Keynesian ideas that governments should trigger growth in the private sector by increasing the amount that was going to public projects. The concept of the Recovery Reinvestment Act is that a government can prevent further deterioration of the economy by offsetting the decreased expenditure in the private sector through increasing the level of expenditure in the public sector. Through the program, the Obama government spent $787 billion in infrastructrue and welfare spending. These fiscal stimulus packages helped the US economy prevent further decline by compensating the losses from the private sector.
Dodd-Frank
The Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) was passed and signed into law with a sole aim of preventing a similar crisis in future. The two main provisions of teh Dodd-Franks are the“Financial Stability Oversight Council“ and “Consumer Financial Protection Bureau“. The Financial Stability Oversight Council has the responsibility of watching over big companies that would cause damage to teh economy if they collapsed (Murdock, 2011). The council does that by monitoring the financial standing for such companies and recommeding fixes that ensure that the companies do not sink in debt or become illiquid. The Oversight Council bears the responsibility of protecting US citizens from events of 2007-8 where the government was forced to spend billions of dollars to rescue companies that had overexposed themselves to the economic crisis.
The Financial Stability Oversight Authority has the powers to influence a breakdown of a large bank into smaller units that do not pose losses to the economy. The decision to break down banks comes from the analysis of the systemic risk for that bank whereby banks that are considered to have huge levels of systemic risk are broken down into smaller units (Murdock, 2011). As noted earlier, the spirit of the formation of teh oversight authority is the idea of ‘better prevention than cure’ and that spending money to control banks is a better investment as compared to spending money to rescue banks in a crisis. This part of the Dodd-Frank is concerned with avoiding a repeat of 2007-8 by creating reforms that help the government to prevent a crisis.
On the other hand, the Consumer Financial Protection Bureau is a section of the Doddy-Frank Act aimed at protecting customers from greedy corporates. The bill protects customers from predatory behaviors of teh finance industry by limiting the fees that mortgage brokers earn when they make a sale (Murdock, 2011). The understanding is that the rush to make a sale and earn a commission obscures teh ability of mortgage sellers to guide their customers well and avoid selling facilities that prove to be very hard for customers to pay. The section assures customers of protection in their attempt to understand the details of a mortgage contract. It ties down sellers to explaining all the pertinent issues and main concepts in mortgage contracts, thus preventing a situation where customers are explouted for their ignorance or lack of knowledge.
The Volcker Rule is another key component of teh Dodd-Frank and its is a form of reinstatement of the Glass-Steagall Act because it instals regulations in the banking sector. Through the rule, banks have to separate their commercial and investment functions (Murdock, 2011). While the rule does not allow banks to form different entities for their commercial and investment wings, it places some requirements on the type of risks that banks are not allowed to take. For instance, a bank cannot take trading risks as long as it is taking deposits from customers. Also, the Volcker Rule has the authority to limit investments by a bank as well as the ability to eliminate propritary trading. The rule repairs most of the problems that were associated with the onset of the 2007-8 crisis. For instance, the rule prohibits banks from associating with hedge funds and private equity firms as teh rule considers such investments to be too risky for a bank.
Other fixes introduced in the Dodd-Frank include protection of whistleblowers from big companies, creating centralized exchanges for credit swaps and regulating the business of credit agencies through the Office of Credit Ratings. Ideally, the Dodd-Franks Act provides fixes to all issues that are thought of as contributing factors in the 2007-8 crisis (Murdock, 2011). The understanding behind the Dodd-Frank is that markets can be controlled and excessive greed from investors checked. The Act outlines long-term fixes that can be utilized to avoid a repeat of the 2007-8 financial crisis by increasing regulation. For many people, the Dodd-Franks is a journey back to the 1980’s where financial institutions were controlled by government bodies. The Dodd-Frank is similar to Financial Services Act, 2012 (UK) that was made to increase protection towards the financial market by reducing instances where the citizens of UK are exploited by the banking system.
Effectiveness of solutions
The short-term solutions that were implemented in the aftermath of the 2007-8 crisis were meant to prevent continued recession that would have eroded the confidence of people in the system as well as their economic activities. On the other hand, the long-term solutions such as Dodd-Frank hold a lot of promise on their ability to correct the wrongs of the financial markets that brought the crisis. While the Dodd-Frank Act offers many solutions to the problems that are thought to have brought the 2007-8 financial crisis, the historical nature of the Act is a limitation because there is no certainty that future problems will emerge from the real estate industry. Perhaps, the misallocation of resources will happen in a different industry that is not covered by the Dodd-Frank, a factor that opens the risk of the Act being insufficient in future. In that regard, it can be argued that the Dodd-Frank does not offer absolute protection for the economy in future.
In 2017, the Republican led Congress in the US proposed a motion that would lead to the removal of the Dodd-Frank Act from the constitution. The current regime in the US supports “small government” and any form of regulation is viewed as a threat to the growth of free markets. It is worth noting that the effectiveness of any law depends on the political support from leaders. The lack of political goodwill can lead to poor implementation or complete repealing, as it is suggested by leaders from the Republican side of the government. The fear is that repealing the Act would expose the US economy again, and that can lead to another financial crisis. The implication is that the ability of the laws passed to regulate the financial interest in the US will depend on the commitment by the political class to implement the provisions of the laws as well as the linkage between future causes of financial crisis and the causes of crises in the past. Therefore, one cannot argue with confidence that the problems that caused the 2007-8 financial and economic crisis can be overcome.
Conclusion
The 2007-8 financial and economic crisis in the US and across the world was caused by a misallocation of resources on the economy where the real estate sector received more than its proportionate share of investment. The result was an unsustainable speed of growth that led to a burst, causing a ripple effect to other sectors of the economy. A number of parties should take a share of the blame for the way things turned out, starting with banks, lenders, government agencies, investment companies and politicians. The crisis was costly for the UK and US government, and both governments have implemented solutions that consider learning from the crisis as the solution to future distress. However, the future is not certain and the problems of the future may differ from those of 2008.
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