The Causes of the Financial Crisis in 2008 - Essay Example

It played a striking role in the failure of key businesses. It also contributed to the decrease in consumer wealth estimated to be in trillions of US dollars and a downturn in economic activities that led to global recession of 2008 – 2012 and also contributed to the European sovereign – debt crisis. It led to the increase of the TED spread that reflected an increase in perceived credit risk. The TED spread is the difference between rates of interest on interbank loans and on short – term U.

S government debt. The spread of TED increase is shown in the graph below: The spread (in red) increases significantly during the crisis. The spread size is usually denominated in basis points e.g. if the bill rate (T - bill) is 5.1% and ED trades at 5.5% then the TED spread is 40 basis points. The TED spread has fluctuated over time but generally has maintained the range of within 10 and 50 basis points except during the financial crisis. In general the financial crisis caused a very big damage to the world economy and many researchers have carried out studies to explain the causes of this crisis.

We try to look into some of the causes below. Imprudent mortgage lending is considered a cause to the crisis as compared to a backdrop of abundance in credit, reduced interest rates, and over the roof prices for houses, lending standard became hassle free enabling many people to engage in the purchase of houses they couldn’t afford. . Competitive pressures contributed to the increase in the amount of subprime lending during the years preceding the crisis. Source: U.S census bureau, Harvard University.

State of the nation’s housing report 2008 The graph shows the dramatic expansion of subprime lending in the U.S between 2004 and 2006. Another cause was the housing bubble where the Federal Reserve allowed housing prices to sour to an all-time high that was unsustainable. Once the bubble burst as it was bound to, it triggered the crisis. The Federal Reserve maintained interest rates artificially low, per month payments to mortgage were low too and housing prices went up. Home owners took equity loans to pay their initial mortgages and credit card debts until the home prices peaked and the house of cards started to crumble.

Mortgage debts would not be increased to pay previous debts. Lack of transparency and accountability in mortgage financing also did contribute to the 2008 financial crisis. Many participants in the housing finance sector contributed to the crisis through the creation of bad mortgages and selling of bad securities with confidence that they won’t be held accountable. Lenders would sell exotic mortgages to home owners without considering the repercussions in case the mortgages failed. Similarly, a trader would sell to investors’ securities that are toxic with fear of personal responsibility in case the contracts failed.

The system collapsed through the maximization of personal gains and passing of the problem down the chain from brokers, to realtors, to individuals in rating agencies, and to other market participants. The great promise of managing risk by the ‘originate – to – distribute’ model of finance failed with