The 2007-8 Financial Crisis: Origins and Failure to Anticipate – Research Paper
The world economy experienced the most desperate financial crisis for decades in 2007 and 2008. The financial crisis was characterized by a downward in the sky-high home prices in the US. This effect spread to the entire financial sector in the US and eventually to financial markets across the world. It is believed that the crisis was witnessed because banks created too much money in a short period and used it to raise house prices as well as in speculating financial markets. Eventually, paying debts became a burden, and these events resulted in the financial crisis that affected many countries. Lewis (2011) paints a vivid picture on what ensued in his book The Big Short. This paper explores the origins of the financial crisis and also provides some insights as to why it is hard to anticipate this financial crisis.
The issuance of mortgages with unfavorable terms by mortgage dealers marked the beginning of the financial crisis (Barrell & Davis, 2008). Most of these borrowers were from families that had not met the criteria for receiving ordinary home loans. Low-interest rates characterized some of these loans during the early years and an increased rate in later years. Since some of these loans had prepayment penalties, it became highly expensive to refinance the loans (Lewis, 2011). Many first time home buyers missed such features with ease most likely because the thought of owning a home with a low income or their inability to afford a down payment may have blinded them. The mortgage lenders sold the loans to banks or two government-chattered institutions (Fannie Mae or Freddie Mac) which had been created to buy mortgages while providing the mortgage lenders with enough money (Lewis, 2011). Fannie Mae and Freddie Mac would then sell to investment banks and in turn receive ‘mortgage backed security’ thereby creating an income stream consisting of the monthly mortgage payments totals (Barrell & Davis, 2008). Those securities (often mistaken as low-risk investments) were then sliced into thousands of smaller pieces and sold to investors.
The insurance industry entered the fray by trading in the “credit default swaps” with the policies indicating that for a fee, any losses resulting from defaults by the mortgage holder would be assumed by the insurer (Barrell & Davis, 2008). In the beginning, it was just insurance, but later there was speculation with financial institutions buying or selling credit default swaps on what were said to be assets that they did not own. According to Lewis (2011), economists ought to have learned from the 1990s’ early failures of subprime loans and therefore avoid providing loans to people who cannot repay them. However, that was not the case.
Everyone profited as long as the prices for housing kept rising. For instance, mortgage holders, who had inadequate regular income sources borrowed against their rising home equity. Securities were ranked as safe- although it is now clear that they were not (Lewis, 2011). The housing bubble enlarged and with time, home ownership reached the saturation point. The Federal Reserve raised rates from June 2004 with the rate reaching 5.25% as of June 2006 (Lewis, 2011). Distress signs were noticeable as early as 2004 with home prices starting to fall in late 2005. When the housing bubble burst, a significant number of mortgage holders were unable to pay their loans due to the high-interest rates and therefore the default rate was very high (Barrell & Davis, 2008). As of September 2007, approximately 3% of all home loans had been placed in the foreclosure process with a 76% increase in a year (Lewis, 2011). It was also noted that 7% of homeowners were behind on their mortgage payments for a month or more which was an increase from 5.6% the previous year (Lewis, 2011). The mild drop in the housing prices which started in 2006 had in some places rapidly transformed into a free fall by 2008. The aftermath was a crisis in confidence because trust in the market economy was significantly low. At this time, governments and financial institution had begun taking measures to prevent further financial disaster.
The first major casualty of the financial crisis was the Countrywide Financial Corp. which was the largest mortgage lender in America. The terms of completing its purchase were agreed by the Bank of America in January 2008. Since the majority of Countrywide’s mortgages were delinquent, it was purchased for $4 billion and a further $2 billion stake acquired in August 2007 (Lewis, 2011). Bear Stearns with huge mortgage-based securities was the second victim. The value of those securities plummeted but JP Morgan Chase rescued Bear Stearns from bankruptcy at $10 per share which totaled to approximately $1.2 billion and the Federal Reserve absorbed the declining assets worth up to $30 billion (Barrell & Davis, 2008). Lehman Brothers filed for bankruptcy, Fannie Mae, and Freddie Mac were placed under the US federal government control, the Bank of America bought Merrill Lynch, and so many other banks and institutions declared bankruptcy (Barrell & Davis, 2008). By late 2008, the Federal Reserve had slashed the rates to about 1% (Lewis, 2011). In efforts to aid world economy, Central banks in China, England Sweden, Canada, Switzerland as well as the European Central Bank had turned to rate cuts. However, the widespread financial meltdown could not be stopped by mere rate cuts and liquidity support.
Reasons for the failure to anticipate the financial crisis
The economy world is full of professionals, but they failed to predict the brewing of the financial crisis. Many professionals have shared the blame. However, of all these, it is the economists who had the best qualifications to anticipate the financial crisis and give a warning of an impending economic disaster. Due to the miss, there has been a lot of soul-searching among economists with many confessing widespread failures. There are arguments that economists were blinded by a free market bias in the profession as well as the use of simplistic and outmoded analytical tools.
According to Franklin Allen, a finance professor at Wharton School (as cited in Wharton School of University of Pennsylvania, 2009) the mathematical models used by most economists did not recognize the critical role of banks as well as other financial institutions in the economy because they did not think they were important. Allen argues that this could have resulted from the academic notion that economic cycles are controlled by the real players – producers and consumers- and therefore financial instructions such as banks are given little importance (Wharton School, 2009). Such is a significant issue given that the crisis was fomented by the financial crisis which created risky products, encouraged lavish borrowing and engaged in high-risk behaviors such as taking prominent positions in the mortgage-backed securities (Wharton School, 2009). As such, use of models that failed to consider the effect of the financial institution was a major reason for not anticipating the crisis.
Furthermore, the Dahlem Report (as cited by Wharton School, 2009) found that most economists did not recognize the long build-up that resulted in the crisis and for that reason, they underestimated it once signs of a crisis were evident. The Dahlem Report implicated mathematical models arguing that they assume that the economies and markets are inherently stable and ignore the different approaches that different economic players use to make a decision, revise forecasting methods as well as the ways they are influenced by social factors (as cited by Wharton School, 2009. Since the financial products offered were poorly understood, any standard analysis using such models failed.
Another argument is that mathematical models used failed to recognize hard-to-measure factors such as what people expect from the future as well as human psychology. Professor Winter (as cited by Wharton School, 2009) argues that economic forecasters failed in common-sense in that there was no way home prices would continue rising at a faster rate to that of household incomes. Instead, they blindingly believed that the housing prices would continue to rise indefinitely. This made the prediction of the crisis hard.
To conclude, I emphasize that the 2007-8 financial crisis was a product of a myriad of factors and failure of multiple institutions. The aftermath was an economic meltdown that affected the world economy. Predicting was difficult due to aspects of the mathematical models used, ignorance by economist professionals and a lack of understanding of the products involves as well as the role of financial institutions. However, there is no doubt that if prudent measures had been taken early as the crisis unfolded, the magnitude of the crisis could not have been the same.
Barrell, R. & Davis, E. (2008). The Evolution of the Financial Crisis of 2007–8. National Institute Economic Review, 206(1), 5-14. http://dx.doi.org/10.1177/0027950108099838
Lewis, M. (2011). The big short (1st ed.). [Harmondsworth]: Penguin.
Wharton School,. (2009). Why Economists Failed to Predict the Financial Crisis – Knowledge@Wharton. Knowledge@Wharton. Retrieved 17 December 2016, from http://knowledge.wharton.upenn.edu/article/why-economists-failed-to-predict-the-financial-crisis/