The Financial Crisis of 2008: Origins, Blame, and Impacts - Essay Example

The Financial Crisis of 2008: Origins, Blame, and Impacts When the biggest financial crisis in US history hit the headlines in the Fall of 2008, theworlds greatest financial gurus pointed fingers in disbelief as if the headlines in the Wall Street Journal were the first inclination they had that a major problem was boiling just beneath the balance sheet. It looked just like the kid that suddenly got caught with his hand in the cookie jar groping in shock for the words that just wont come and simply mumbles; What? Politicians and executives alike sounded the alarm and stressed the need to act immediately by making billions of dollars available for bailouts and buyouts. When Pennsylvania Avenue and Wall Street both agreed that there is no time to lay inappropriate blame, and investigations would not be constructive, it became apparent that the blame would eventually be spread thin and impersonally. Clues would come weeks later, as cooler heads prevailed and thoughtful minds deliberated the financial processes that had left our banking system broken, frozen, and no cash flowing. As the origins of the crisis began to reveal the presence of neglect and greed, the public began to get a picture of how it happened and who was to blame. Unbridled capitalism, fuelled by a Friedmanian business mentality, exploited the economic system and self-perpetuated a growing, yet hidden, under-capitalization that nurtured the inevitable crash. Ronald Reagan had unleashed capitalism from the chains of regulation in 1980, and the pro-market attitudes would experiment for the next 25 years finding out how little regulation could effectively maintain control of the economy. De-regulated airlines teetered on the brink of bankruptcy. Utilities, without the moderation of an independent regulator, were pricing electricity out of the reach of the average California worker. These warnings went unheeded, and the first commandment of free market economics became "The business of business is business"1. Business ethics were simplified and responsibility was cast aside in favor of a new belief that said, "The social responsibility of business is to increase its profits" (Friedman, 1970). By the late 1990s, the mortgage, insurance, banking, and financial sectors had caught the current of the new wave of extremist capitalism that had been shepherded in just twenty years earlier. Economic theories that bordered on moral philosophy became justified in the minds of financiers that were willing to turn their head to the exploitation in the belief that intervention was a form of intrusion. The next ten years would provide specific opportunities to further inflate the economic value of financial instruments, whose only regulation was the markets reaction to their ability to turn a profit. The origins of the financial crisis had sown its seed in deregulation and the moral justification for excessive greed had taken root. Problems of under-capitalization and instability began to manifest themselves as the creative financial transactions of sub-prime loans, bundling, and the credit default swap combined to eliminate the protection offered by traditional security and transparency. Subprime loans began to become more prolific in the years between 2001 and 2006 when the amount of the loans quadrupled (Crouhy, 2008, p.9). As the demand for housing rose, so did the cost of real estate. This led to market speculation where housing prices continued to escalate, and homebuyers expected to refinance before the reset and accumulate some secure equity (Crouhy, 2008, p.11). The deregulation mentality contributed to this cycle as the "Huge demand from investors for higher yielding assets, such as super senior tranches of subprime CDOs, led to a lowering of lending standards, low-documentation, and even no-documentation loans" (Crouhy, 2008, p.11). The under regulated practice of bundling allowed these risky loans to be combined with more secure instruments, and a creatively deceptive insurance scheme gave the bundles an appearance of a AAA rating for what was essentially a junk bond. These were used to further collateralize loans until it suddenly became apparent that the entire framework was built on hot air and mirrors. As investors wanted out of the market, and there was no new money coming in, housing prices began to fall. Credit Default Swaps, short selling, and hedging kicked in at this point to further destabilize the banking system. Swaps are a form of default insurance. As the riskiest loans began to default, "doubts form about a companys soundness; creditors want more protection, so they try to buy credit default swaps; sellers of swaps engage in short-selling to hedge their own exposure; the companys stock and bond prices lose value; creditors get even more worried" and the vicious cycle continues in a downward spiral (Kling, 2008). This left banks, insurance companies, pension funds, and homeowners upside down in their investments and a system that was on the verge of collapse. It would require hundreds of billions of dollars to shore up the insurance companies, remove the bad loans from the lenders who were suddenly unable to do business due to a poor credit rating, and help rectify the negative equity situation of the individual homeowner. While there were numerous forces at work, the origins of the failure can be found in the attitude that advocated an almost religious respect for non-intrusion in the market and a mantra that promoted profit making at any cost. The financial crisis is so broad and encompassing that it is not possible to lay the blame on any individual, political party, cultural group, or corporation. Some people are guilty of exploiting their profits and contributing to the illusion of security and collateral. Politicians are guilty of advocating the questionable economic theories that would tie them to Ronald Reagan and increase their political chances by being associated with the popular national figure. Democrats and Republicans were guilty of neglecting their responsibility and failing to provide the adequate oversight that could have halted and punished those that violated the spirit of our banking system. Speculators and private homeowners were guilty of over-optimism at best, or fraud at the worst. Shiller (2008) blames the general public and their "irrational public enthusiasm for housing investments" (p.4). The financial industry, that lived by the creed of profits, were guilty of allowing this system to continue knowing the fragility and instability in the system would lead to the eventual collapse and doing nothing. Yet, most were operating within the letter of the law, and riskier times meant greater profits. Rather than taking chances, they were fulfilling their misguided obligation to capitalism and the free market. The effects of the crisis would reverberate across the globe impacting stock markets and the major exchange centers around the world. Great Britain suffered, and continues to be impacted, by similar events that have taken place in the US. The UK has been confronted with bank failures and an estimated cost of containment that rises daily. Britain has taken the unprecedented step of semi- nationalizing eight of their leading banks (Dodge, 2008). However, the UKs problems do not stop at their borders. As many as 116 local government councils have invested the taxpayers money in the Icelandic banks that have failed as a result of the international fallout, and losses could approach 1 billion pounds (Dodge, 2008) .In addition, hundreds of thousands of individuals and British firms have deposits in Icelandic banks, and Moscow is trying to develop a solution. These unfortunate developments will cause a similar result as in the US with higher inflation, an economic slowdown, and a rising unemployment rate. In conclusion, the origins of the financial crisis lie in the changing attitudes of the 1980s when America began to experiment with deregulation and unbridled capitalism. While the financial theories of supply side economics and the enthusiasm for Friedmans free market policies generated wealth for some, but widened the income gap and placed the middle class at risk of a financial collapse. There was no holding it back once the process took hold, as almost everyone was benefiting from the CEO on down to the average homeowner. However, most of the wealth was built upon a deceptive paper chase and was destined to return to real value at some point in time. Everyone who participated in the system, or turned their head in benign neglect, has to share some of the burden of blame. In the UK, local governments and thousands of investors stand to lose as much as $1 billion pounds that was considered safe in Icelands once secure banking system. Going forward, we should learn our lessons and not let history repeat itself. Capitalism has been proven to be incapable of self-regulation, and the social responsibility of business extends to operating in an honest and credible manner with integrity and transparency. References Crouhy, M. (2008). The subprime credit crisis of 2007. Paris: NATIXIS Corporate and Investment Bank. Dodge, A. I. (2008, October 22). Financial crisis has odd effects in UK. Retrieved October 24, 2008, from http://pajamasmedia.com/blog/financial-crisis-has-odd-effects-in-uk/ Friedman, M. (1970, September 13). The social responsibility of business is to increase its profits. The New York Times Magazine. Retrieved October 24, 2008, from http://www.colorado.edu/studentgroups/libertarians/issues/friedman-soc-resp-business.html Kling, A. (2008, October 3). Credit default swaps. Retrieved October 24, 2008, from http://econlog.econlib.org/archives/2008/10/credit_default.html Shiller, R. J. (2008). The subprime solution. Princeton NJ: Princeton University Press. Read More