Financial Crisis and Housing Bubble, Research Paper Example

The year 2014 is already in its fifth month and the nation’s economy has still not fully recovered which demonstrates the severity of the 2008 financial crisis and housing bubble. Anyone who closely followed the 2012 Presidential Elections coverage may be aware of the fact that the economic recovery was one of the major debate topics.It is important to understand the causes of the 2008 financial crisis and housing bubble so that such factors could be avoided or at least identified in timely fashion to take corrective measures. The analysis of the causes shows that the 2008 financial crisis and the housing bubble was not caused by single factor but multiple factors.

When interest rates are low, lenders such as financial companies seek new ways to earn money and this was one of the major factors behind the housing boom that eventually crashed and contributed towards 2008 financial crisis. The Federal Reserve Bank (Fed)started lowering interest rate in late 2001 to help U.S. economy recover from recession and the low interest policy remained in effect until 2004. The low cost of borrowing money encouraged the construction industry to embark on nonstop development spree. Similarly, lenders were more than willing to lend to any potential homeowner who applied for credit in order to earn from volume. The high demand for real estate property led to record values and new homeowners felt pressured to borrow even more, encouraged by their rising net worth. It is estimated household consumption was responsible for two-third of the U.S. GDP growth. Home equity loans totaled $700 billion in 2004 or approximately 5 percent of the nationalGDP in the U.S(Lim). When the value of an asset reaches unrealistic valuations due to high demand, correction has to occur sooner or later because unrealistically high values are not sustainable as we witnessed during the internet boom. Not surprisingly, housing market eventually collapsed and played a huge role towards the 2008 financial crisis.

The financial sector has a reputation for engineering new products on regular basis in search of new revenue streams. Unfortunately, complex financial products can also lead to problems as the 2008 financial crisis shows. The newly-engineered products by the financial sector such as the mortgage-backed securities were too complex for most finance professionals to understand and even the traders who traded these securities. As a result, most market players severely underestimated the risk underlying these securities. Not only finance professionals including traders but even credit rating agencies had trouble understanding the true risk profile of such complex financial products and not surprisingly these credit rating agencies slapped AAA grading on many high-risk securities (Jickling). In other words, one of the factors behind the financial crisis was the result of extremely high risk taking by the players, often unknowingly. The cumulative risk profile was so high for certain financial companies like Bear Stearns and Lehman Brothers that they went out of business.

One of the factors behind the 2008 financial crisis was poor management of conflict of interest by the industry participants of which one example may be the relationship between credit rating agencies and the companies who securities are graded by the credit rating agencies. The credit rating agencies earned revenues from the very companies whose securities they were obliged to rate. Thus, the integrity of credit rating agencies was also compromised to some extent bythe fact that they depended for revenues on companies whose securities they were grading and as a result, they had an incentive to be generous towards the clients in order to attract more business. Thus, in addition to the difficulty of understanding the complex financial securities, the desire to please clients might also have influenced credit rating agencies’ decision to give AAA rating to many mortgage-backed securities that were, in fact, junk(Jickling).

Another factor behind the 2008 financial crisis was the poorly-designed compensation policies on Wall Street. Like many companies, Wall Street was also overly focused on short-term performance and compensation policies were designed accordingly. The real performance is not always evident at the end of the year but may takes years to fully realize but financial market participants were mostly compensated on the basis of year-to-year performance (Jickling). As a result, traders and other finance professionals adopted generous approach towards risk-taking in order to hit record annual numbers and enjoy attractive compensation packages in the process. This generous attitude towards risk taking may also be evident from the fact that Wall Street earned about $27 billion from trading in asset-backed securities. This frequent trading added layers upon layers to the securities and made them extremely difficult if not impossible for most people to understand(Lim). Hence, it is not a surprise that their risk profile was severely underestimated by most finance professionals including traders.

The 2008 financial crisis was also caused by unethical behaviors by companies such as off-balance sheet accounting. This was nothing less than intentionally misleading investors by hiding the true liabilities of the company and leading investors to overpay in their investments. Some banks also tried to hide their true liabilities and, thus, overall risk profile by creating off-the-books special purpose entities(Jickling). Once again, investors were unknowingly taking greater risk as well as overpaying.

The analysis of the 2008 financial crisis shows that some people and even organizations fail to learn lessons and repeat the same mistakes over and over. Unrealistic financial models had led to troubles in the past but once again financial modeling experts developed computer models that underestimated risk and ignored very low probability events. In addition, the computer models were prepared on the basis of insufficient data covering only few years(Jickling). This was another example of how poorly individuals and even companies understood their risk.

The purists who prefer free market system without any intervention from the government may also have to reassess their beliefs because one of the factors behind the 2008 financial crisis was lack of adequate government oversight of the actions of the financial sector players. Fed may be a systematic risk regulator but it doesn’t have the authority to monitor investment banks, hedge funds, and dealers etc.

It may also be reasonable to assume that one of the factors behind the 2008 financial crisis and housing market collapse was one which is almost always present in times of boom and bust, i.e. group-thinking. Financial market participants do not always engage in rational manner and are influenced by emotions including greed. When everyone is doing well, there is a temptation to follow the suit whether its investment banks competing with other investment banks or individuals investing in stocks or real estate. Similarly, when it was apparent that the housing market was overvalued and financial securities such as mortgaged-back securities had higher inherent risk than initially realized, everyone panicked and starting selling. Just as group-think led to boom times before the crisis, it also led to collapse of the financial sector and the housing market.

Just like the Great Depression, the U.S. Government played a major role in easing the pain of the crisis and preventing the economy from further deteriorating. First of all, the Fed lowered the interest rate to record low level(Censky) in order to encourage borrowing by both businesses and consumers. When interest rates are low, businesses and consumers borrow more due to low cost of financing and their investment and spending activities promote economic activity and, thus, boost GDP. Another measure was the U.S. Government’s Troubled Asset Relief Program (TARP) which bailed out many financial institutions whose collapse would have otherwise derailed the economy. The government also bailed out the automobile sector which turned out to be a success, also creating hundreds of thousands of jobsin the process (The Department of the Treasury).

It is clear that the 2008 financial crisis and the housing sector collapse has been one of the most severe economic crisis in the US over the last century and the national economy still has not fully recovered. It was triggered by a range of factors including low interest rates, speculative activity in the housing sector, easy lending to homeowners, complex financial securities, and lack of government insight. It is important to understand these causes so as not to allow another crisis of the same magnitude though some mistakes do repeat themselves as the financial sector demonstrated by relying on unreliable financial models.

Works Cited

Censky, Annalyn. Fed to keep rates low until 2014. 25 January 2012. 7 May 2014 <http://money.cnn.com/2012/01/25/news/economy/fed_rates_bernanke/index.htm>.

Jickling, Mark. Causes of the Financial Crisis. CRS Report for Congress. 9: April, 2010.

Lim, Michael Mah-Hui. “Old Wine in New Bottles: Subprime Mortgage Crisis – Causes and Consequences.” The Journal of Applied Research in Accounting and Finance 2008: 3-13.

The Department of the Treasury. The Financial Crisis Response in Charts. April 2012. 7 May 2014 <http://www.treasury.gov/resource-center/data-chart-center/Documents/20120413_FinancialCrisisResponse.pdf>.