Financial Crisis of 2007-2009

The financial crisis of 2007–2009
In 2008, interest rates in the US were only 1%, and people thought that it was
not safe to put their money in the bank, even the stock market started to
fall, so they started looking for assets from which they could get higher
returns. That's when real estate housing came into the picture.
Owning a home is part of the traditional “American Dream.”In the early

2000s, that dream came into reach for a growing number of people. The
changes in banking laws began in the 1980s that allowed banks to offer
mortgages* to subprime customers. (Subprime refers to borrowers or loans,
usually offered at rates well above the prime rate, that have poor credit
ratings). Consumers took advantage of cheap credit to purchase durable
goods such as appliances and houses.
The demand for mortgages drove up the demand for homes that home
builders were trying to meet because of the ease of credit. Many people
bought homes as an investment to sell as prices continued to rise. Lenders
believed that homes made good collateral, so they were willing to lend
against real estate and earn revenue while things were good (and if
borrowers ever defaulted they could sell the property for a good price).
These loans were then bundled with high-quality loans and issued as
Mortgage Backed Securities (MBS). Banks were able to pass the risk on to
investors, so they were happy to approve loans to people who didn't have
the proper documentation or a good credit rating. Soon the tax rate
increased from 2.25% to 5.25%. Plagued by huge interest rates, defaults only
increased.
When the Fed raised interest rates, the resulting increase in mortgage
payments put pressure on borrowers' ability to pay. Property prices soared
as supply began to outstrip demand. High-interest rates combined with
falling home prices made it very difficult for buyers to pay for their homes.
This trapped homeowners who could not afford to buy and sell homes.
When the value of derivatives crashed, banks stopped lending to each other.
This triggered the financial crisis that led to the Great Recession. And in late
2007, the economy officially plunged into recession.
Note:
*A mortgage is a legal agreement by which a bank, building society, etc. lends money at interest in
exchange for taking the title of the debtor's property, with the condition that the conveyance of title
becomes void upon the payment of the debt.
Reasons for the crisis :
The subprime mortgage crisis was a result of too much borrowing and
flawed financial modeling, largely based on the assumption that home
prices only go up. Greed and fraud also played important parts.Many
scholars and journalists have argued that moral hazard played a role in the
2008 financial crisis, since numerous actors in the financial market may
have had an incentive to increase their exposure to risk. Moral Hazard occurs
when a party or a person engages in a risky behavior or decision where another
entity bears most of the cost in that particular decision or event that lead to an
unfavorable outcome.
Even people with bad credit could qualify as subprime borrowers.In a June
2009 speech, U.S. President Barack Obama argued that a "culture of
irresponsibility" was an important cause of the crisis. He criticized executive
compensation that "rewarded recklessness rather than responsibility" and
Americans who bought homes "without accepting the responsibilities." He
continued that there "was far too much debt and not nearly enough capital
in the system.
Risky borrowers: Borrowers were able to borrow more than ever before,
and individuals with low credit scores increasingly qualified as subprime
borrowers. Lenders approved “no documentation” and “low
documentation” loans, which did not require verification of a borrower’s
income and assets (or verification standards were relaxed).
Risky products: In addition to easier approval, borrowers had access to

loans that promised short-term benefits (with long-term risks). Option-ARM
loans enabled borrowers to make small payments on their debt, but the loan
amount might actually increase if the payments were not sufficient to cover
interest costs. Interest rates were relatively low (although not at historic
lows), so traditional fixed-rate mortgages might have been a reasonable
option during that period.
Fraud: Credit rating agencies were telling the investors these

mortgage-backed securities were safe investments. They gave a lot of these
mortgage-backed securities AAA ratings. The investors were desperate to
find more and more of these securities. Lenders did their best to create
more of them. To create more of these mortgage-backed securities lenders
loosed their standards and gave out subprime mortgages
Eventually, some institutions even started using predatory lending

practices to generate mortgages. They made loans without verifying
income and offered absurd adjustable-rate mortgages with payments people
could afford at first, but quickly ballooned beyond their means.
Lenders were eager to fund purchases, but some home buyers and
mortgage brokers added fuel to the fire by providing inaccurate information
on loan applications. As long as the party never ended, everything was fine.
Once home prices fell and borrowers were unable to afford loans, the truth
came out.
Steps taken to solve the crisis
Federal Reserve (Fed) tried to rescue the big bank and financial institutions
which were on the threshold of bankruptcy. In order to rescue some of
important America’s banks Fed created a moral hazard on a huge scale,
making a vague impression that the government guarantee that certain
financial institutions are “too big to fail”, companies with extremely high
risk such as Bear Stearns, AIG, Fannie Mae and Freddie Mac were guarantee
by the government(Harris 2012). However, this action actually encourages
reckless, irresponsible behaviour.
Dodd-Frank
The most influential measure was the Dodd-Frank Wall Street Reform and
Consumer Protection Act, which introduced steps designed to regulate the
financial sector's activities and protect consumers. Signed into law in July
2010, Dodd-Frank brought sweeping reforms to the U.S. financial sector.
Consumer Financial Protection Bureau (CFPB) and Financial Stability
Oversight Council (FSOC) were introduced through this measure.
Emergency Economic Stabilization Act

In October 2008, a divided Congress passed the Emergency Economic
Stabilization Act, which initially provided the Treasury with approximately
$700 billion to purchase "troubled assets," mostly bank shares and
mortgage-backed securities. The budget was subsequently reduced to $475
billion and the Troubled Asset Relief Program, as the program was known,
ultimately spent $426.4 billion bailing out institutions.
Lessons from the 2008 crisis
The financial crisis demonstrated that confidence in the financial market

cannot be quickly restored once it has been severely damaged.
In a world that was becoming increasingly interconnected, a relatively
localised liquidity crisis in the United States very quickly became a
large-scale crisis of confidence for the entire world.
Without the policy decisions that were made in the wake of the 2007
financial crisis, it’s been suggested that more than 17 million jobs would have
been lost in the United States alone (which is almost twice the actual
number), financial markets would have contracted for almost double the
length of time that they did, and the global economy would have been far
weaker than it was pre-Coronavirus.
Even if only hypothetical, the 2007/8 financial crisis has shown that both
action and inaction can have serious economic repercussions. The silver
lining is that after every global economic crisis in the past, markets have
always been able to forge new beginnings.
Lessons for India
● The years since the global financial crisis of 2008 have brought into
sharp focus the importance of managing financial stability in a
country.
● In India’s case, however, when we focused on growth, we allowed
financial instability from twin deficits, banking stress and inflation to
set in. This led to our own economic crisis in 2013. We have now
adopted a flexible inflation-targeting framework. Fortunately for us,
global crude oil prices subsided in 2014.
● Economic policymaking is complex. In our Indian context, each time
we try and simplify this by focusing on one metric alone, we risk
aggravating overall financial stability. We may have no option but to
consider financial stability as a whole – across external balance, fiscal
health, and the health of our financial sector, besides growth and
inflation. We also need a coordinated effort from the government and
the central bank, to optimize and address financial stability as a whole.

Financial Crisis of 2007-2009

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Financial Crisis of 2007-2009

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The financial crisis of 2007–2009

Owning a home is part of the traditional “American Dream.”In the early

Reasons for the crisis :

Risky products: In addition to easier approval, borrowers had access to

Fraud: Credit rating agencies were telling the investors these

Eventually, some institutions even started using predatory lending

Steps taken to solve the crisis

Emergency Economic Stabilization Act

Lessons from the 2008 crisis

The financial crisis demonstrated that confidence in the financial market

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