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The US financial crisis of 2008 - Essay Example

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The US financial crisis was a process and not an event. Signs of fragility in the financial sector were present from 2007. This continued and a tipping point reached in Sept. 2008, when a number of large financial institutions based in the US collapsed…
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The US financial crisis of 2008
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Download file to see previous pages It is not easy to identify the precise cause of the crisis. There were a number of factors that contributed to the crisis. The combination of the diverse factors led to a toxic potent mix that eventually reached a tipping point in September 2008, heralding the beginning of the full-blown financial crisis. The causes of the crisis can be divided into two. In the first group, there are long term structural problems within the US economy. These were deeper latent issues that existed for some time with seemingly no ill effects to the economy. The first was too much debt. From 1980 to 2007, the total debt per person in the country rose from just below US $ 4 000 to around US $ 30 000 (Federal debt per person US 1). The perception that the housing market had perfect price inelasticity fuelled the debt accumulation. Americans using the value of their homes for refinancing believed the value of their homes will continue rising without affecting the demand for housing. This debt levels were too high for a healthy economy. The looming structural deficits also played a role. Medicare and Social Security off-balance sheet debt was likely to increase the US insolvency, reducing investor confidence on the country. The US has had trade deficits consistently for some time. The deficits are mostly because of the dollar having a reserve currency status and undervaluing of the Chinese Yuan. This led to the decline of the US export industry, and the dependent manufacturing base. Internal deficits mirror the external trade deficit. The government cannot borrow indefinitely, and the large internal deficits contributed to the crisis (Jickling 2). The rating agencies had a hand in the crisis. The market relies excessively on the ratings given by the rating agencies. Laws and regulations that allow the use of ratings as a basis for permissible investments buttress this dependence. However, the rating agencies have a poor regulatory framework. The rating agencies are an oligopoly and, did not provide accurate rating assessments. Some of the AAA ratings given to the subprime mortgage-backed securities were later downgraded to junk status. Rating agencies' failure was due to use of poor economic models, conflicts of interest and poor oversight. The US tax code was also a contributory factor. The tax code is inefficient and has complex rules. It also has tax expenditure subsidies exploited by the suave Wall Street operators. Another factor leading to the outbreak of the financial crisis is deregulation of the financial sector and the markets. The SEC in 2004 liberalized the net capital rule. Consequently, investment bank holding companies were free to run extremely high leverage ratios (Jickling 3). The SEC's Consolidated Supervised Entities meant to police the largest investment banks was an ineffective voluntary program. Other laws, for example, the Commodity Futures Modernization Act (CFMA) and the Gramm-Leach-Bliley Act (GLBA) give financial institutions carte blanch to undertake risky transactions that were unregulated in a vast scale. The laws placed too much faith in self-regulation and robustness of the market. By 2007, most financial institutions had accumulated large debts with dubious credit worthiness. The deregulation led to the invention of spurious financial instruments that enriched the financial sector at the expense of everybody else. In this category, the ...Download file to see next pagesRead More
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