Reasons the 2008-2009 Economic Crisis, and policies implemented to save it
The Great Recession 2008-2009 as measured in terms of depth, breadth, and duration or its far reaching effect in asset markets has been dubbed as the most serious global financial crisis in the 21st century since the Great Depression of the 1930s (Krassel, 2011). The causes of the present economic and financial crisis have continued to attract great attention and publicity. To this effect, a number of explanations and theories have been brought forth about the proximate triggers of the financial crisis itself.
According to popular opinion of many financial analysts, the financial crisis that befell the United States during 2008-2009 has its roots in the mortgage lending markets. The signs of the looming economic crisis started to show as early as 2007 (Kamalodin, 2012). The Federal Loan Mortgage Corporation (commonly referred to as Freddie Mac or Freddie) made it public that it would discontinue its purchasing of high-risk mortgages. This was immediately followed by a filing for bankruptcy by the New Century Financial Corporation – a top mortgage lender to high risk customers.
The full flare of the crisis emerged as house prices begun to dwindle and the number of foreclosures shot up dramatically. This forced credit rating agencies to start downgrading their individual risk assessments of asset-supported financial instrument in mid 2007 (Epstein, 2009). The increased risk limited the ability of the issuers of the financial products to repay interest. This in effect brought to light the fact that the breaking of the US housing and credit bubbles held hidden losses for asset-backed financial instruments. As a result, approximately $1.9 trillion of mortgage-supported securities got downgrades to represent the reassessment of their risk which greatly reflected an immediate and worse dislocation of the financial markets.
Following the ensuing tight credit markets, the US Federal Reserve (Fed) supported mortgage and financial firms through such interventions as short-term lending facilities along with auctions for the purpose of selling the mortgage-associated financial products. Nonetheless, such measures seemed to have come too late as they did not prevent the rapid declines in asset prices as agencies strived to relieve themselves of the risky burdens and boost their already risk-weighted capital ratios (Krassel, 2011). In January 2008, mortgage lender Countrywide Financial was purchased at $4billion by Bank of America while many of the rest of the firms saw their credit ratings downgraded.
By and large, the greatest sufferer of the troubles affecting the mortgage-backed securities was the large American investment Bank, Bear Stearns, which had invested heavily. The Bank was massively affected was it was then unable to recapitalize satisfactorily to cover its great losses. This meant that it was in no position to continue operations when its stock price collapsed by March 2008. In the month, Bear Stearns was taken over by Morgan Chase in a government-aided acquisition.
In light of the above scenario, the following reason have come to generally accepted as the proximate causes of the financial crisis that affected US in 2008-09 and which there is yet to be full recovery.
i) The crash of the US housing bubble and the finance industry
In the period between 1998 and 2005, the US house prices shot up dramatically beyond double and also far quicker than average wages. Further evidence of the presence of a bubble was in form of the ratio of the house prices to renting costs which reached its high around 1999. In addition, it was realized that that the inflation-adjusted house prices in the US had stayed relatively constant in the period 1899-1995. Therefore, the creation of a housing bubble was a result of rise in house prices which was because of the increased demand for housing in the United States because of low interest rates, support for the subprime market, and positive property speculation (Krassel, 2011).
The collapse of housing bubble happened in 2006 due to a number of factors. First, there was a decline in the average hourly wages in US since 2002 up to 2009. Owing to the fact that housing increasingly became unaffordable, the prices were halted from rising.
The collapse of housing bubble in the US endangered the overall returns from mortgage-backed assets. One, default translated into halting of large cash flow. Second, there was significant depreciation of dependent housing collateral. As a result, the US economy suffered more than $1tr following the fall of the subprime market. However, the web of financial instruments on which the subprime market was constructed around was the ones that magnified the damage.
There were a number of problems relating to the complex financial instruments which served to broadened the decline of the US housing market to the financial sector at large. Many formal and informal models fell short of integrating common shocks, and did not consider to unlikely yet highly costly tail risks. In addition, the contemporary statistical methods employed in banks, insurance firms and CRAs made projections based in archaic housing date generally going as a far a couple of decades and which did not show the relaxation of credit standards (Ciro, 2012). Unfortunately, these models were unable to accommodate the likelihood of a critical recession where mortgage-owners would default en masse. Additional informal models employed by speculators, mortgage lenders and homeowners were projected on the assumption that the current price growth along with expansionary monetary policies would persist. On the contrary, this was never to be.
ii) The fall of Lehman Brothers and the Global Credit Freeze
In early 2000, the Lehman Brothers was successful, profitable and an active player in innovative financial markets and products. The firm offered its customers complex financial solutions while gaining significant windfall gains. However, the firm faced the risk of inherent pile-up of risk it was absorbing, a scenario that was worsened by the increasing asset prices propelled by low interest rates.
The Us Federal Reserve in conjunction with the US Department of the Treasury intervened to save the firm from filing for bankruptcy. The strategy involved purchase of the net assets of Lehman Brothers by the Barclays Bank in the UK. However, the buyout did not materialize because the Financial Services Authority (FSA) failed to approve Barclay’s plan. The FSA did feared that Barclays risked being burdened with Lehmann’s large debts together with future repayment obligations. The stalemate between the US Federal Reserve and US Treasury on one hand, and the FSA on the other forced Lehman to file for bankruptcy. Lehman’s bankruptcy, with estimated debts exceeding $US600 billion, was the largest in US corporate history. This had instant far-reaching effects on stocks markets across the globe. The Dow Jones Industrial dropped in excess of 500 points in a one day.
Immediately thereafter, credit and debt market started to seize up which resulted in stressful consequences in the real economy. The confidence in the financial markets of the world soon begun taking a beating. Worse though, the apparent freezing of credit markets from the start of 2009 progressed unchecked throughout the first half of 2010 (Ciro, 2012). The normal operation of credit markets was interrupted following the restriction and refusal of lenders to lend money fearing the borrowers would be unable to repair the loans. Collateral lost relevance as banks stiffened lending standards as a result of fall in prices of real estate and asset prices. Majority of businesses, investment banks along with other financial institutions faced imminent collapse.
It is worth noting that the financial and credit were bound to continue on their downward spiral were it not for the instant policy response from the US Treasury and the US Federal Reserve, together with governments and central banks in the UK, the European Union (EU) and elsewhere. Efforts have been channeled towards ensuring that the world’s major industrialized economies remain protected from such systematic risk and contagion as well as from the risk of complete collapse.
iii) Opaque Financial Markets
By and large, the financial markets of the world contributed heavily to the financial crisis of 2008-09. Evidence shows that the crisis was largely fueled by the build-up in inherent risk relating to the US and global housing bubble. In addition, it is believed that the creation of exotic and sophisticated financial instruments (such as the CDO and credit default) brought about confusion among investors who had secured billions of dollars in securitized residential mortgage securities which had now been rendered valueless. By the time housing bubble started to deflate in the US, the inherent build-up of risk had indeed already spread to banks, investors, pension funds, investment funds, and municipal authorities across the world (Marshall, 2009). As such, it correct to say the contagious residential mortgage-backed securities that originated in US financial markets had been re-designed, re-packaged and labeled anew, and exported to global investors.
The US government intervened through Troubled Asset Program (TARP), where it institutions were afforded the power to offload the poisonous assets they had unknowingly stored on their respective balance sheets. The Bush Administration in liaison with the US Treasury relied on the constitutional enactment – the Emergency Economic Stabilization Act of 2008 to establish the US TARP (Ciro, 2012). As much as $US700 billion was availed by the TARP for the purchase of toxic sub-prime mortgage-based assets from US financial institutions. Under TARP, the US Treasury has the freedom to purchase toxic assets in a well graduated roll-out consisting of three tranches: i) $US250b at any one time; ii) $US350b at any time, given there is Presidential certification to Congress; iii) $US700b at any one time, provided there is formal report to Congress from the US Treasury with budget details.
In summary, US TARP enables Treasury to buy illiquid, hard-to-value assets from financial institutions and banks. It is targeted to boost the liquidity of the assets by buying them through secondary market mechanisms and thus enabling participating institutions to stabilize their respective balance sheets and avert subsequent losses.
In addition, TARP aims to encourage banks and other financial institutions to resume lending money as before the crisis to each other, businesses and consumers (Marshall, 2009). The US government hoped that increased lending would translate to loosening of credit and thus restoring order to the troubled financial markets besides improving investor confidence in the markets and financial institutions.
Role of the President
President Barrack Obama inherited a government that was deep in the financial crisis but has done much during his first term to recover the US economy. The President has implemented or proposed several initiatives and financial policies that are consistent with those of the Progressive Economists’ statement. These include these five most significant elements:
i) Short-term macroeconomic stimulus program
The President in conjunction with the Federal Reserve have fronted significant short-term stimulus programs: a) monetary policy initiatives, b) the American Recovery and Reinvestment Act ( the fiscal policy stimulus package), c) policies to challenge the home foreclosure crisis, d) initiatives to inspire global coordination of the expansionary macroeconomic policy
ii) management of financial saving and reconstruction efforts
In line with the Progressive Economists statement, the Obama administration has appreciated the need to utilize its public investment found in financial institutions to modify the activities of these banks and second the economic recovery in the short term and assist the longer-term rebuilding of the US economy.
iii) medium and long-term fiscal policy initiatives
The longer term macroeconomic policies together with green policy initiatives adopted by President Obama have greatly complimented those of the Progressive Economists’ program. The president has done well with his preliminary budget document – “A New Era of Responsibility: Renewing America’s Promise” (Epstein, 2009). The longer term (10 year) plan represents a transition from the neo-liberal era characterized by business dominance and inequality. It introduces a new business order where there is increased shared growth and government plays a more central management-cum-investment role.
Similarly, President Obama has encouraged major investment in a green energy economy through the “Cap and Trade” program (Epstein, 2009). Permits are thus sold to place manufacturing firms as well as energy utilities in the US allowing them to emit greenhouse gases and afford them freedom to trade the permits.
iv) Financial reform plus regulation
Under the Obama administration, plenty blueprints for reform have been developed and are under implementation. The key areas of focus have been: systemic risk; eliminating gaps in the regulatory structure; protecting consumers and investors; fostering international coordination.
v) international initiatives designed for macroeconomic and financial management
The Obama administration has responded to the need to have major reform of the current international economic structure (Epstein, 2009). The Obama administration has made efforts to see surplus countries such as China increase their domestic demand, cut reliance on exports and transform into an engine of global economic growth.
However, the failing of the Obama administration is the area of management of the financial turmoil, including salvaging and reconstruction of banks. Similarly, the current administration has been sluggish and tentative in proposal of longer term financial reforms.
Critique of the recovery programs
However, US TARP has not been a success story as initially intended. This is because some players in the financial industry have not used the money for the purposes it was meant. There have been cases where investors have been abused following the passing of the TARP legislation – investors have been cheated that their monies were invested in nonexistent federal TARP financial rescue programs (Marshall, 2009). Criticism has been such that insufficient and inadequate information about the use of the money by companies translates that the program is highly vulnerable to fraud such as conflicts of interest, collusion between players, and vulnerabilities to money laundering. The first fraud case involving TARP was reported by the SEC on January 19, 2009, against Pro-Trust Management and its owner Gordon Grigg. The most recent such case happened in October 2010 where the FBI accused former president-cum-chief executive of the Park Avenue Bank, Charles Antonucci, of making untrue statements to regulators so as to obtain some $11 million from the TARP fund.
Likewise, the difficulty to understand the aim of the fund has lent it to much criticism. For instance, many bank executives identify lending as a priority. Furthermore, the fund is regarded as a no-strings-attached windfall open to be utilized to pay down debt, purchase other businesses or make future investment. It has also been widely noted that majority of the bank holding companies have spent a modest fraction of the funds to recapitalize their bank subsidiaries (Kamalodin, 2012). This is evidenced by the report of the Senate Congressional Oversight Panel that oversees TARP which held that there was no evidence showing the US Treasury utilized TARP funds to boost the housing market by curbing preventable foreclosures.
Summary
In summary, it is clear that the proximate trigger of the financial crisis has to be the collapse of the US housing market together with the subsequent surge in mortgage loan defaults. Policymakers in the US have strived to implement various fiscal stimulus packages targeted at supporting the eroded economy (Marshall, 2009). Aggressive and consistent government intervention is needed to mitigate the financial crisis. The US government has taken upon itself to nationalize some of the troubled financial systems meaning that currently the government produces almost all the residential mortgage loans of the country.
The US Federal Reserve has also greatly expanded its role. The Fed has established a zero interest rate policy which remain indefinite in the effort to reduce long-term interest rates (Ciro, 2012). Furthermore, the Fed has launched a quantitative easing policy where money is effectively printed to purchase securities as well as offer loans to financial institutions that rely on their securities as collateral.
References:
Ciro, T. (2012). The Global Financial Crisis: Triggers, Responses and Aftermath. Farnham, Ashgate Publishing.
Epstein, Gerald. (2009). Obama’s Economic Policy: Achievements, Problems and Prospects. Retrieved from: http://regulation.revues.org/7459
Kamalodin, Shahin. (2012). Financial Crisis Investigation: What were the causes of the global financial crisis in 2008/09? Retrieved from http://www.rabobank.com/content/images/WP1201ska_Financial_Crisis_Investigation_tcm43-158638.pdf
Krassel, P. (2011). Feasting Dragon, Starving Eagle. Philadelphia, Casemate Publishers.
Marshall, John. (2009). The financial crisis in the US: key events, causes and responses. Retrieved from: http://www.voltairenet.org/IMG/pdf/US_Financial_Crisis.pdf
Verick, S. & Islam, I. (2010). The Great Recession of 2008-2009: Causes, Consequences and Policy Responses. Retrieved from: http://ftp.iza.org/dp4934.pdf
