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Causes Of The 2008 Financial Crisis

972 words - 4 pages

Financial crisis
The financial crisis occurred in 2008, where the world economy experienced the most dangerous crisis ever since the Great Depression of the 1930s. It started in 2007 when the home prices in the U.S. Dropped significantly, spreading very quickly, initially to the financial sector of the U.S. and subsequently to the financial markets in other countries.
The victims in the United States were: the largest commercial banks, the whole investment banking industry, the major savings and loans, the largest insurance company, and the two enterprises licensed by the government to smoothen the progress of mortgage lending.
The monetary policies that caused the financial crisis were that the Federal bank reserves provided banks with new funds that enabled them to make loans and investments. The process led to increase in money supply which in due course increased the rate of spending (Flores, Leigh & Clements, 2009). Eventually, the increase in spending over and beyond the capacity the economy to produce goods and services led to inflation.
The expansive monetary policy. It propagated the asset boom that lowered the interest rates and induced borrowing past the sensible bounds to acquire the asset. The government also played a role in increasing demand for houses through proselytizing the benefits of home possession for the welfare of individuals as well as families.
Flawed financial innovations: the implementation of innovations in investment instruments such as derivatives, securitization and auction-rate securities before markets. The indispensable fault in them is that it was difficult to determine their prices. “Originate to distribute securities” was substituted by securitization which facilitated the increase in household leverage. Further innovations in banking ,especially the performance of the derivatives industry made the lending of mortgages worse, making the risk, specifically the fundamental property of derivatives become so difficult that neither the buyer nor the designer of these instruments the risk imposed by them.
The collapse of trading. One of the instruments was the collapse of the long-term auction rate security, for which the rate of interest is periodically reset at auctions. Thus the number of bidders was fewer compared to the number of securities sold. This resulted to the securities being priced at a penalty rate. Hence the investors are not able to redeem their money and the issuers have to pay a higher rate to borrow.
Easy credit conditions. The low interest rates encouraged borrowing and thus there was increase in demand for various kinds of financial assets, leading to increase in prices of these assets whilst lowering the interest rates. This led to the housing bubble deflating. The low rates were worsened by the modern financial instruments, for instance collateralized debt obligations (CDOs) and the MBS.
The Federal Reserve responded to the crisis by lowering its major federal funds rate, in...

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