1. News & Issues

Your suggestion is on its way!

An email with a link to:

http://useconomy.about.com/u/ua/Financial-Crisis/What-Caused-2008-Global-Financial-Crisis.htm

was emailed to:

Thanks for sharing About.com with others!

Readers Respond: What Caused the Global Financial Crisis of 2008

Responses: 4

By

The financial crisis was primarily caused by deregulation in the financial industry that permitted banks to engage in hedge fund trading with derivatives.

Deregulation

First, the 1999 repeal of Glass-Steagall by the Gramm-Leach-Bliley Act. This allowed banks to use deposits to invest in derivatives. Banking lobbyists said they couldn’t compete with foreign firms, and that they would only go into low risk securities, reducing risk for their customers.

Second, the 2000 Commodity Futures Modernization Act allowed the unregulated trading of credit default swaps and other derivatives. This federal legislation overruled the state laws that had formerly prohibited this as gambling.

Who wrote and advocated for passage of both bills? Texas Senator Phil Gramm, Chairman of the Senate Committee on Banking, Housing and Urban Affairs. He was heavily lobbied by Enron where his wife, who had formerly held the post of Chairwoman of the Commodities Future Trading Commission, was a board member. Enron was a major contributor to Senator Gramm’s campaigns. Federal Reserve Chairman Alan Greenspan and the former Treasury Secretary Larry Summers also lobbied for the bill’s passage.

Enron and the others lobbied for the Act to allow it to legally engage in derivatives trading using its online futures exchanges. Enron argued that legal overseas exchanges of this type was giving foreign firms a competitive advantage.  (Source: Eric Lipton, “Gramm and the ‘Enron Loophole,”New York Times, November 14, 2008.)

Big ban had the resources to become very sophisticated at the use of these complicated derivatives. As banking became more competitive, the banks that had the most complicated financial products made the most money, and bought out smaller, stodgier banks. That’s how banks became too big to fail.

Securitization

How did securitization work? First, hedge funds and others sold mortgage-backed securities, collateralized debt obligations and other derivatives. A mortgage-backed security is a financial product whose price is based on the value of the mortgages that are used for collateral. Once you get a mortgage from a bank, it sells it to a hedge fund on the secondary market.

The hedge fund then bundles your mortgage with a lot of other similar mortgages. They used computer models to figure out what the bundle is worth based on the monthly payments, total amount owed, the likelihood you will repay, what home prices and interest rates will do, and other factors. The hedge fund then sells the mortgage-backed security to investors.

Since the bank sold your mortgage, it can make new loans with the money it received. It may still collect your payments, but it sends them along to the hedge fund, who sends it to their investors. Of course, everyone takes a cut along the way, which is one reason they were so popular. It was basically risk-free for the bank and the hedge fund.

The investors took all the risk of default. They weren’t worried about the risk because they had insurance, called credit default swaps.  They were sold by solid insurance companies liked AIG. Thanks to this insurance, investors snapped up the derivatives. In time, everyone owned them, including pension funds, large banks, hedge funds and even individual investors. Some of the biggest owners were Bear Stearns, Citibank, and Lehman Brothers.

The combination of a derivative backed by real estate, and insurance, was a very profitable hit! However, it required more and more mortgages to back the securities. This drove up demand for mortgages. To meet this demand, banks and mortgage brokers offered home loans to just about anyone. Banks offered subprime mortgages because they made so much money from the derivatives, not the loans.

The Growth of Subprime Mortgages

In 1989, the Financial Institutions Reform Recovery and Enforcement Act increased enforcement of the Community Reinvestment Act. This Act sought to eliminate bank “redlining” of poor neighborhoods, which had contributed to the growth of ghettos in the 70s. Regulators now publicly ranked banks as to how well they “greenlined” neighborhoods.  Fannie Mae and Freddie Mac reassured banks that they would securitize these subprime loans. It was the “pull” factor that complimented the “push” factor of the CRA.  (Source: John Carney, “The Phony Time-Gap Alibi for the Community Reinvestment Act,” Business Insider, June 26, 2009)
 

How the Fed Suckerpunched Subprime Borrowers

Banks really needed this new product, thanks to the 2001 recession (March-November 2001).  In December, Federal Reserve Chairman Alan Greenspan lowered Fed funds rate to 1.75%, and again in November 2001, to 1.24%, to fight recession. This lowered interest rates on adjustable –rate mortgages. The payments were cheaper because their interest rates were based on short-term Treasury bill yields, which are based on the Fed funds rate. 

Many homeowners who couldn't afford conventional mortgages were delighted to be approved for these interest-only loans. Many didn’t realize their payments would skyrocket when the interest reset in 3-5 years, or when the Fed funds rate rose.

As a result, the percent of subprime mortgages doubled, from 10% to 20%, of all mortgages between 2001 and 2006.  By 2007, it had grown into a $1.3 trillion industry. The creation of mortgage-backed securities and the secondary market was what got us out of the 2001 recession. (Source: Mara Der Hovanesian and Matthew Goldstein, "The Mortgage Mess Spreads," BusinessWeek, March 7, 2007

It also created an asset bubble in real estate in 2005. The demand for mortgages drove up demand for housing, which homebuilders tried to meet. With such cheap loans, many people bought homes, not to live in them or even rent them, but just as investments to sell as prices kept rising. 

Other Reasons That Could Have Contributed

Was it over-lending by Fannie Mae and Freddie Mac? Did Federal Reserve Chairman Ben Bernanke and others ignore obvious signals of impending economic doom, such as the inverted yield curve and the melt-down in the sub-prime mortgage market. Perhaps it was banks' reliance on chasing profits from mortgage-backed securities and other derivatives. This was aggravated by investments like hedge funds, which were poorly regulated by the SEC. Or, was it simply greed by businesses, the government and even home-buyers who bought homes they knew they couldn't afford? Here's what readers said.

GLOBAL ECONOMIC WHEEL

We are not getting it right in all we assune to be the cause of reoccurring crisis either finacial, economic or whatever... The global economy is formed and operates on a global structure with respect to time. Presently all economies of the world are sitting on a shaky foundation thereby subjected to continuous challenges. The absence of the exact global economic wheel design and implementation among various world nations is the practical cause of both past,present and future crisis...this is because the global economy in its form and functional mode is a 360 degree economic wheel that plies the path of sustainability under a time axis of 8760hrs/annum. If what we have is an interconnected globe,we need a framework to do the global interconnected structure that will support various interconnected policies,planning/management strategies to see the global economy through reoccuring crisis. The global economy needs a wheel urgently.
—rexlumen

Predator Nation has all the answers

Just read "Predator Nation" by Charles Ferguson who also wrote "Inside Job." Seems to me he had almost everything correct. READ IT!!!
—Guest Joan Galt

2008 Meltdown

In 2008 several factors were at play as mentioned in previous articles but they are only the outward manifestations of the underlying problem of today’s society. We as a society have not learned to find peace with our everyday lives so we look to other means. While money may solve several continuing problems, it in itself cannot provide happiness. So try as many might, the search for contentment through excess spending and greed, whether in business or personal endeavors is doomed for failure. 2008 was just another point in time in which the tipping point was exceeded.
—dfundy

Deregulation

Read "13 Bankers" by Simon Johnons. It's all laid out there. Hedge funds and all those derivatives you mentioned weren't regulated. Banks and AIG were allowed to use depositors' money to make risky investments. Fannie and Freddie did the same with government guaranteed funds. They were private companies and knew the government would bail them out. Nothing has changed. Wall Street is bleeding Main Street dry, and who's stopping them?
—Cre8iveForce

©2015 About.com. All rights reserved.