The financial meltdown of 2008 impacted the global economy on an unimaginable scale. Many economists consider it the worst financial crisis since the Great Depression of the 1930s. It resulted in the threat of a total collapse of the global financial system, the bailout of many major banks by national governments, and downturns in stock markets around the world. In many areas, the housing market also suffered, resulting in foreclosures and prolonged unemployment. With the large collapse, naturally, the blame is being pointed in many different directions, but mostly towards the United States Government’s Housing Policy. Some critics believe misguided laws and over-grown sponsored agencies allowed unethical lending and directly caused the crisis. This post will further reveal that the government housing policy did not cause the financial crisis. The cause of the crisis can be linked to predatory mortgage products, loosely regulated securitization and derivatives markets, and the failure of government regulators to crack down on the massive risk being taken by our nation’s financial institutes.
Predatory Subprime Lenders
Predatory subprime lenders contributed to the cause of the financial crisis by participating in unethical and deceptive lending practices. Many firms, such a Countrywide financial, took part in classic bait-and-switch methods, advertising low interest rates for home financing (Sanchez, 2013). Such loans were constructed into extensively detailed contracts, and swapped for more expensive loan products on the day of closing. Over time, as rates started increasing rapidly, consumers were unable to fulfill their loan obligations. The Community Reinvestment Act, which requires banks and savings associations to meet the credit needs of all segments of the community, only accounted for 6 percent of the high-cost mortgages during the time of 2004-2006 (Sanchez, 2013) and therefore cannot be blamed for causing the financial crisis. Likewise,by the time Fannie Mae and Freddie Mac lowered their underwriting standards in 2006, they were too late to the game to cause the subprime frenzy (2013).
Securitization and Derivatives Market
Next, the unruly securitization and derivatives market heavily influenced the destruction of the financial industry. Prior to the crisis, many financial institutions became highly leveraged, increasing their tolerance of risky investments and reducing their recoil in case of loses. A majority of this leverage was achieved through the use of complex financial instruments such as off-balance sheet securitization and derivatives (Scott, 2010). From 2004-2007, the top five U.S. investment banks each significantly increased their financial leverage which increased their vulnerability to a financial shock (2010). The changes in capital requirements allowed lower risk weightings for AAA securities. This caused the risk contained in subprime mortgage-backed securities to spread throughout the entire financial system.
Lastly and perhaps the most significant cause of the financial crisis was financial deregulation. The failure of government regulators to eliminate predatory lending and over-leverage by financial institutions greatly impacted the crisis. The 1999 repeal of the Glass-Steagall Act effectively removed the separation between investment banks and depositary banks in the United States. The Gramm-Leach-Bliley Act
, also known as the Financial Services Modernization Act of 1999, further removed barriers in the market among banking companies, securities companies,and insurance companies that prohibited any one institution from acting as any combination of an investment bank, a commercial bank, and an insurance company. Additionally, causing more risk, the Commodity Futures Modernization Act of 2000 allowed financial products such as credit default swaps to expand without oversight.
In conclusion, it is evident that the United State Government Housing Policy did not cause the financial crisis of 2008. The true cause of the crisis was due to predatory mortgageproducts, out of control securitization and derivatives markets, and the failure of government regulators to crack down on the massive risk being taken by our nation’s financial institutes. To eliminate future financial shock, our government should effectively create a well regulated housing system that serves families and strengthens communities.
Kuttner, Robert. “Don’t Blame the Dream of Home Ownership”. The Huffington Post. 3 June, 2014. Web.
Sanchez, David. “No, Lending to Poor People Did Not Cause The Financial Crisis”. Think Progress. 15August, 2013. Web.
Scott, Kenneth. “Fixing the Financial System”. Journal of Applied Corporate Finance. Volume 22, Issue 3. Summer 2010. Web.