The Subprime Financial Crisis, Essay Example

The recent 2007 financial crisis which was triggered by the subprime mortgage market meltdown is the costliest financial crisis since the Great Depression of the 1930s (Paletta, Ng and Hilsenrath). The subprime mortgage crisis has its earliest roots in the loose monetary policy of the Federal Reserve Bank beginning late 2001 that was intended to pull the U.S. economy out of the recession. The loose monetary policy remained in place until the end of 2004. Low interest rates meant that the money was cheap to borrow which encouraged ambitious home building projects by the construction industry as well as similarly never-ending demand by the potential home owners. Because of strong demand, housing prices escalated to unrealistic levels which didn’t reflect the true value of the properties. At the same time, capital continued to flow into the U.S. and homeowners, feeling rich due to soaring value properties responded by borrowing even more. It’s no surprise that household consumption accounted for two-thirds of the GDP growth. Home equity loans reached a high of $700 billion in 2004 or about 5% of the U.S. GDP. But U.S. Fed, home builders, and U.S. consumers were not alone in their irrational behavior (Lim).

Because interest rates were low, banks and loan providers could not make money the traditional way to which they responded by loosening qualification criteria for borrowers in order to take advantage of scale. Many people got loans to which they would never have qualified under normal circumstances, given their income and net worth. Background checks as well as verification of data provided by applicants on their applications were often ignored which would have caught false information in many instances. The banks and lending institutions were just focused on scale and the employees obliged in order to meet performance targets by generously approving loan applications. The financial industry churned out innovative products such as securitized products which bundled loans from customers with different credit risks. These securitized products were deemed safe because they were thought to have achieved diversification by bundling together loans of all kinds of risk categories. But the confidence was often misplaced and in many cases securitized products magnified risk instead of reducing it. This is because no one really understood securitized products that would go through different intermediaries before ending in the hands of the final buyers and thus, they didn’t adequately understood the risk they were inheriting (Klarman).

The government also failed to do its job. Many of the largest financial institutions went into new lines of businesses since the repeal of Glass-Steagall Act which created several conflict of interests. Glass-Steagall Act forbade banks from owning other financial institutions such as investment banks and insurance companies (Bergenjerseyforeclosures.com). But the government failed to address these conflict of interests. In addition, the U.S. Department of Housing and Urban Development (HUD) ignored warnings of trouble even though the regulators were warning as early as 2004 that subprime lenders were issuing loans mortgage borrowers could not afford. HUD encouraged Freddie Mac and Fannie Mae to make investments in subprime loans as a gesture of goodwill towards public and between 2004 and 2006, the two federal agencies purchased $434 billion in securities backed by subprime loans. Freddie Mac and Fannie Mae’s role towards the subprime crisis cannot be ignored since they both together finance about 40% of all U.S. mortgages (Leonnig).

When the bubble finally busted, lending institutions found that a significant portion of their loan portfolio had lost its value. Many homeowners that mistakenly believed that home values only go up over time found themselves with negative net worth since the value of their homes were now much less than what they owed. Leading investment banks Lehman Brothers and Bear Stearns went out of business and the government had to provide hundreds of billions in assistance to struggling financial titans including AIG, Bank of America, Wells Fargo, JPMorganChase, Citigroup, and even Goldman Sachs that was once considered infallible (ABC News).

The recent financial crisis raises the question whether the government has an ethical responsibility to regulate markets to a greater extent than what the staunchest believers in free market economy support or the government should restrict its role as much as possible and let the free market economy monitor itself. The author believes that more rather than less government regulations than the current level is required for the efficient functioning of the economy but it is important to first consider the position of those who oppose greater government intervention in free market economics. When one thinks about the supporters of free market economics, Milton Friedman is one of the first names that come to mind. Milton Friedman opposed Keynes argument that government should tackle unemployment by increasing demand for goods and services, even at the expense of inflation. Keynes had so much confidence in the efficiency of the free markets that he went on to say, “Nobody spends someone else’s resources as carefully as he uses his own.” Milton Friedman has even been called by some as the patron saint of free market economics (Khadem). In Friedman’s view, government should keep its hands of the economy, to let the free market do its work. The only economic intervention Friedman thought the government may hold is the supply of money (Noble).

If Friedman were alive, he would most probably oppose increasing government regulation of the financial markets in the wake of the recent financial crisis. Friedman may argue that government doesn’t understand the workings of financial industry as well as the financial industry does and he may blame the crisis on Federal money supply policies since the beginning of last decade. Other free market supporters may also argue that free market system may not be absolutely perfect but it’s still the most efficient economic system in the world. They may add that the biggest difference between free market system and communism is the degree of government intervention and the reason countries with free market prospers is due to the minimum government’s role in the functioning of the markets. Free market supporters may also blame fed for keeping rates too low for too long as well as encouraging Freddie Mac and Fannie Mae to loosen qualifying criteria of home loans. Most free market supporters may also oppose the U.S. government bailout of leading financial institutions on the premise that failure of some leading financial institutions would have been a free market mechanism that weeds out inefficient players.

Some of the arguments by free market supporters do have logical support but free market supporters sometimes fail to realize that economies are almost never entirely free or communist in nature but instead a mixture of both. Their ultimate label is usually determined by the most dominant market system which in the U.S. case is free market based capitalist system. This is because even in free market economics, there are some services that cannot be provided by the private sector due to the nature of their economics. Education and police security are some of the examples. Thus, even free market economics require a minimum level of government intervention to ensure the proper working of markets. The supporters of free market economics also believe that markets are efficient by nature and can correct themselves. If markets were truly efficient, we would not have investors like Warren Buffet that have consistently beaten the markets and have made billions in the process. Markets can only be efficient if they are logical and we human do not always make logical and rational decisions but are prone to emotional judgments. This is why market panics are accompanied by stock sell-offs even though the underlying economics of some companies may not have deteriorated as much as what their stock prices may indicate. Even if we blame the Fed for ineffective monetary policy, it had no role in financial innovations such as mortgage backed securities that were traded. Most people in the market didn’t understand them yet bought and sold them. Logical pricing decisions can be made only when underlying values are known but the trade in mortgage backed securities was driven by greed rather than actual understanding of their underlying values.

Supporters of the free market economics also fail to realize that companies do not always make logical decisions because they often overstate the link between risk and profits. Moreover, their tendency to take risks is also encouraged by the moral hazard of ‘too big to fail’ which means they realize that their size will always result in government assistance should they run into difficulties. Unfortunately, this moral hazard will always be there as even Warren Buffet admitted that taxpayer bailouts of the financial sector will sometimes be necessary (Alden). Supporters of the free market economics may argue that the government should not have bailed out the failing institutions but they gravely underestimate the consequences of not doing so. According to Phillip Phan, professor of management at the Johns Hopkins Carey Business School in Baltimore, AIG collapse would have taken down the whole insurance industry with it (Son and Lanman).

Most of us would agree that the financial crisis was triggered by activities in few of the industries such as financial industry and construction industry etc. but it affected the whole U.S. economy, even totally unrelated industries that had to fire employees and reduce production. The U.S. government has an ethical responsibility to ensure that the economy keeps functioning well because what happens in the economy affects everyone from the businesses to the general public in both positive and negative ways. Thus, the government has a responsibility to regulate economic sectors, especially ones with far reaching consequences such as the financial sector as we have seen that markets do not always act logically and when they do engage in irrational behavior, they could risk the entire economic system. In fact, if it were not for government interventions we would have lot more economic crisis. One of the responses to the bank runs during the Great Depression of the 1930s was the creation of FDIC that insures every deposit up to a certain amount. This helps prevent bank runs in the U.S. because the public feels safe due to the government’s guarantee. In addition, there was a real risk of economic meltdown in the wake of 9/11 tragedy as the economy was already in recession had the Fed not stepped in with liquidity guarantees to the market (CNBC).

If nothing else convinces the supporters of free market economics of a greater government intervention which is also government’s ethical responsibility in order to prevent future crisis, they should consider the fact that even the lifelong supporters of free market economics have altered their point of views now. U.S. ex Treasury Secretary as well as former head of Goldman Sachs, Hank Paulson declared in 2008 that raw capitalism is dead (Sloan and Serwer). This shows that Hank Paulson had finally realized that maybe markets are not really as efficient as he thought they were and he is one who once headed probably the most powerful private institution in the U.S. financial sector. This is not to say that free market economics are flawed; free market economics is still the most efficient economic system in the world and history proves that but there is no such thing as absolutely free market economics. Even the freest economic systems require government intervention to function properly because the participants in the free market economics do not always act rationally and are sometimes guided by emotions. This is why we witness irrational behavior in the markets that should not happen were the markets really capable of monitoring themselves without any external help. This is also government’s ethical responsibility because what happens in the markets affects everyone from businesses to individual citizens, even those who didn’t do anything wrong and yet have to face the consequences of the actions of the few. Thus, government regulation is not only a sound policy but also government’s ethical responsibility towards its citizens.

References

ABC News. ABC News’ Survey of 16 TARP Banks. 17 December 2008. 24 July 2011 <http://abcnews.go.com/Business/Business/story?id=6479932&page=1>.

Alden, William. Warren Buffett: ‘Too Big To Fail’ Will Never Be Resolved. 11 February 2011. 24 July 2011 <http://www.huffingtonpost.com/2011/02/11/warren-buffett-too-big-to-fail_n_821814.html>.

Bergenjerseyforeclosures.com. Repeal of Glass-Steagall Act cause of housing boom? 9 August 2008. 24 July 2011 <http://www.bergenjerseyforeclosures.com/blog/info/entry/repeal_of_glass_steagall_act>.

CNBC. Greenspan’s Cheap Money. 24 July 2011 <http://www.cnbc.com/id/31187744>.

Khadem, Nassim. Milton Friedman, patron saint of free-market economics. 18 November 2006. 24 July 2011 <http://www.theage.com.au/news/business/milton-friedman-patron-saint-of-freemarket-economics/2006/11/17/1163266781427.html>.

Klarman, Seth. Securitized Products Were Too Good of an Idea to Pass On. 24 July 2011 <http://www.investorwords.com/tips/1101/securitized-products-were-too-good-of-an-idea-to-pass-on.html>.

Leonnig, Carol D. How HUD Mortgage Policy Fed The Crisis. 10 June 2008. 24 July 2011 <http://www.washingtonpost.com/wp-dyn/content/article/2008/06/09/AR2008060902626.html>.

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.

Noble, Holcomb B. Milton Friedman, 94, Free-Market Theorist, Dies. 17 November 2006. 24 July 2011 <http://www.nytimes.com/2006/11/17/business/17friedman.html>.

Paletta, Damian, Serena Ng and Jon Hilsenrath. Worst Crisis Since ’30s, With No End Yet in Sight. 18 September 2008. 24 July 2011 <http://online.wsj.com/article/SB122169431617549947.html>.

Sloan, Allan and Andy Serwer. How Financial Madness Overtook Wall Street. 18 September 2008. 24 July 2011 <http://www.time.com/time/printout/0,8816,1842123,00.html>.

Son, Hugh and Scott Lanman. AIG Told U.S. Failure May Cripple Banks, Money Funds. 9 March 2009. 24 July 2011 <http://www.bloomberg.com/apps/news?pid=newsarchive&sid=av8IskE9DZ4A>.