In this paper, I will discuss what factors lead to the credit crisis in 2008, explain what could have prevented it, and elaborate on which policies the United States (U.S.) government have proposed will have the best chance of succeeding in recovering the economy in the long-run.
What factors led to the credit crisis of 2008?
The credit crisis of 2008 was due to many factors. The first factor involves the pre-crisis condition of the financial markets. There was a global 'savings glut' from countries like China, Japan and Germany. As such, since the desired savings tend to be larger than desired investments from these countries, real long-term interest rates fall, which allows homeowners and banks to borrow money at very low costs. As housing prices tend to be price inelastic downwards, residential property was regarded to be a good investment. Hence demand for houses increase, which also led to an increase in demand for residential mortgages, thus beginning the housing bubble in the United States.
The second factor involves financial institutions that borrow excessively to buy mortgage loans and sell them to investors for a profit. Banks engaged in securitization, which is the process of repackaging these mortgage loans into Mortgage-Backed Securities (MBS), of which the most common MBS is Collateralised Debt Obligations (CDO). Financial institutions sell CDOs to investors based on different risk and return categories called tranches, which are prioritized based on mortgage payments collected first by the bank from homeowners. Banks would then lower their risk exposure to these CDOs by using credit default swaps (CDS) as a form of insurance measure, hence allowing these products to receive better ratings from credit rating agencies such as Moody's.
Another aggravating factor would be the poor judgments of rating agencies in determining risks of these MBS. As rating agencies perceive that it was highly unlikely that housing prices nationwide would fall and that large amounts of loans would default at the same time, they rated higher priority tranches very safe due to their low risks. Rating agencies also catered their services specifically to banks' needs to attract more customers, and it was unclear how these agencies rated MBS. As a result, with high credit rating of their MBS, banks were able to sell their structured products at high profits to investors who perceive these MBS as safe investments with high return, while spreading their risks among buyers around the world.
Overall, these three factors combined led to an increasing number of investors turning to MBS as a lucrative form of investment. Funds entering the market from all over the world greatly increased the liquidity for real estate purchases. As an increasing demand for MBS ensued, financial institutions sought mortgage originators to provide them with more mortgages. However, credit-worthy homeowners have already bought mortgages to most of their homes. As most mortgage originators were paid based on the volume of mortgage loans processed rather than the quality of those loans, and given low interest rates and cheap credit for individual homeowners, financial institutions lowered their credit requirements and turned to low-income, non-credit worthy home buyers, giving rise to subprime lending. Little documentation of homeowners' financial background was needed, with little or no downpayment required of their homes. As a result, as homeowners bought homes which they were unable to afford, household debt grew enormously. By 2006, rise in interest rates made refinancing of these homes more difficult, and there were an increasing number of defaults and foreclosures as homeowners were unable to pay off their loans.
With a fall in housing prices, financial institutions were now unable to sell their MBS as their MBS became very risky. As these financial institutions used leverage to finance their products, they needed to sell these assets to pay back their debts and minimise losses, hence leading to a rapid decline in prices of these securities. Also, given the economic circumstances, banks were uncertain of other banks' financial conditions, which caused them to stop lending money to each other. Hence, financial institutions were unable to obtain short-term funds to finance their daily operations, causing a downward spiral of banks' financial conditions as they were now unable to obtain cash and cash equivalents to pay off their debts. As most of the banks sold MBS, a sudden freeze in net cash inflows have resulted in losses amounting to billions of dollars.
The adverse effects of the rise in homeowner defaults were immediately seen. Banks all over the world were going bankrupt, as can be seen in the U.S. where major financial institutions such as Merrill Lynch faced major liquidity problems and had to be bought out by Bank of America, while other major banks such as Lehman Brothers filed for bankruptcy. Many other financial institutions, such as A.I.G., Fannie Mae and Freddie Mac, which faced massive debts, were also rescued by the government in order to prevent the whole financial sector from falling deeper into recession. The start of the credit crises that originated in the U.S. began to reach out to Europe, where European financial institutions that invested heavily in U.S. MBS faced huge liquidity problems. The report stated that mortgage banks including Northern Rock and Bradford & Bingley had to be nationalised, and governments around Europe intervened by injecting capital into the financial market to save the economy from going bankrupt. The chronology of events that occurred in the U.S. and branched out to the rest of the world as stated eventually led to the credit crisis of 2008.
What could have prevented the credit crisis?
On hindsight, 2 prevention measures could have prevented the credit crisis. Firstly, higher capital requirements on financial institutions could have prevented the financial crisis. According to the report, the Basel Committee's minimum requirement for a bank's capital adequacy ratio was only 4% of the bank's risk-adjusted assets, as compared to the 15% to 25% of a bank's assets before the Great Depression in the 1930s. Given the high amount of risks involved, this ratio was perceived to be too low. Hence, increasing the amount of a bank's capital to its risky assets, in this case MBS, could have allowed banks to better weather losses in times of an economic downturn.
Secondly, the credit crisis could also have been prevented if financial institutions did not issue subprime mortgages to less credit-worthy individuals. Short term profits were prioritized to long term repercussions, which ultimately led to the failure of major financial institutions. As stated in the article, the CDS market was "largely unregulated and opaque, comprised of privately negotiated contracts among fund managers and broker-dealers". Also, as most banks were "too big to fail", governments had to buy them to prevent them from going bankrupt, a situation that may have wide repercussions to the global economy. An increase in regulation towards financial institutions, especially those that are specified as "too big to fail", as well as regulations towards credit rating agencies would not only help to protect consumers, but would also have potentially prevented the credit crisis from happening.
Which of the proposed plans for reforming the financial industry have the best chance of succeeding?
Comparing the different economic proposals, I believe that the American Recovery and Reinvestment Act would have the best chance of recovering the financial industry both in the short-term and the long-term. The act is a stimulus package that includes spending on education, healthcare and infrastructure, as well as to help homeowners cope with refinancing their mortgages. In the short term, with a downturn in the economy, an increase in public spending would help to offset the decrease in private spending, minimizing the economic impacts of the credit crisis on unemployment. Besides the short term impacts of government spending to spur the economy, long-term business projects that benefit society will also be funded by the government through the act, such as increasing spending on education and research and development, thereby helping to contribute to economic growth in the long run.
I also feel that improvements made by G20 and the Basel Committee on regulations would help to strengthen the financial system. The credit crisis was due in part to lax regulations on the CDS markets as well as improper governance of credit rating agencies that rate highly toxic MBS. Having a uniform international system of financial guidelines that govern how financial institutions operate would help to reduce gaps in the financial system, while requiring banks to hold more liquid reserves would help to reduce the vulnerability of banks in cases of bank losses, thus aiding in reducing the severity of future crises.
The US government also proposed the "Obama Levy" that aimed to tax banks with over $50 billion in assets. I believe that such a rule would not be beneficial to the economy as higher tax rates on bank assets would turn away potential investors due to a decrease in returns on their investments, thereby hindering the inflow of funds both domestically and from foreign firms. High tax rates would also slow down the growth of firms as they have less incentive to expand their businesses, thereby reducing production, employment and economic growth in the long run.
