How Has the Financial Crisis of 2007 Affected the Economy of the US - Case Study Example

How has the Financial Crisis of 2007Affected the Economy? : The Case of the United States Name: Unit: Course: Professor: Submission Date How has the Financial Crisis of 2007Affected the Economy?: The Case of the United States Introduction: Historical Background The global financial crisis that swept across the entire global economy between 2007 and 2008 left many people vague about its causes and its effects on the world economy. The roots of the financial crisis can probably be traced to financial markets’ deregulation in the Western European economies, the US, and the UK that began in the 1970s and took effect in 1980s. The deregulation removed regulatory controls by governments leaving organizations free to trade widely across activities and territories. Before the deregulation, banks, stockbrokers, building societies, and insurance companies specialized in their spheres of trade. Geographically, the operations of these institutions were constrained to their countries. With deregulation, these financial institutions were allowed to operate and make money from financial markets worldwide. Liberalization of credit was the effect since borrowing was made easier making it easy to expand personal debt, especially mortgage debt. The effects were initially felt in the property sector, and later to other sectors of the economy (National and International Issues 2015 p.2). Financial institutions led huge amounts of money to people whose credit worthiness was questionable, and when interest rates rose, the people could barely afford the repayment of their mortgage loans. Default rate increased to record levels with the sub-prime loan defaulters unable to pay their loans. The impact of the defaults cut across the entire financial system because banks and investors had purchased many of the mortgages and other Collateralized Debt Obligations (CDOs), including bonds and assets (BBC NEWS 2009). The credit crunch was occasioned by increased liquidity and loose monetary policy (Martin &Milas 2009 p.1). It was a series of an event after event beginning from low-interest rates and increased lending by banks to sub-prime borrowers, to increased house prices and speculation on financial markets, to the high default rate, then the financial crisis, and finally reduced bank lending that resulted in shrinking of the economy. Therefore, the great recession that began in 2007 can be associated with lax lending standards that increased personal debts and caused real-estate bubbles, housing policies by the US government, and failure to regulate fully non-depository financial institutions. The US Housing Sector and the Financial Crisis The financial crisis in the US began in the US housing market in the 1990s due to low-interest rates, lax lending, and speculations in the financial market. For instance, financial institutions seeking to maximize profits engaged in complex financial processes that were characterized by poor risk analysis, highly leveraged borrowing, and limited credit regulation. The housing bubble burst in conjunction with other asset bubble instigated the credit crisis. Various financial innovations ensued to reduce the risk only to cause its spread to the financial markets and also to the real economy. Before the late 2008 crisis, policy institutions in the US seeking to address liquidity concerns, prevent mortgage foreclosures, and stimulate demand came up with various policy responses. The policy responses included legislation aiming at mortgage foreclosure mitigation and stimulation of demand, Bear Steams bank to be taken over due to its failure, and the creation of the Federal Reserve (Fed) to lower interest rates and enhance liquidity schemes to abate credit crisis. However, financial crisis crept in with the fall in house prices and downgrading of mortgage-based securities to reflect risk reassessments of late 2007 and early 2008. The financial shocks of 2007/2008 changed the approach. The US Treasury was given the mandate to administer the Emergency Economic Stabilization Act that was passed by the Congress in 2008. The Bank of Lehman Brothers that had collapsed due to the financial crisis was not bailed out by the Fed and the US Treasury. Capital injections into economically troubled financial institutions were administered by the US Treasury in exchange for common equity stakes and preferred stock. AIG, an insurance company that had collapsed, was bailed out by the Fed and the Treasury. The short-selling of financial institutions was suspended by the Securities and Exchange Commission. The government launched Stability and Homeowner Affordability Plan to enable refinancing of mortgages by struggling homeowners. The $787 billion American Recovery and Reinvestment Act were passed to strengthen US economy’s demand. However, these actions failed to prevent a rapid decline in asset prices because institutions wanted to get rid of risky burdens and restore their capital ratios. Increased default rates coupled with rapidly declining asset prices posed problems to mortgage lenders in assessing the value of collaterals and many mortgage institutions collapsed due to the sinking of their dividend, credit, and strength ratings (Marshall 2009 p.3). From the Housing Sector to the Banking Industry The financial crisis crept from the housing sector to hit the banking industry in late 2008. The collapse of the housing bubble left two critical issues behind; a high default rate and depreciation in the housing collateral. The financial crisis entered the banking industry with serious impacts. For instance, the investment bank Lehman Brothers was declared bankrupt on 15th September, 2008 due to failure to raise enough capital to enable it to underwrite its downgraded securities. Its failure demonstrated the government unwillingness to bail out all financial institutions, especially banks, causing a spike in lending rates among banks. Other banks collapsed in very short intervals including the investment bank of Merrill Lynch that was purchased by the Bank of America on 16th September 2008. The American International Group (AIG) faced liquidity problems due to its downgraded credit ratings, but was bailed out by the combined efforts of Fed and the US Treasury. For greater capital access, Morgan Stanley and Goldman Sachs that were the only remaining investment banks became bank holding companies. Washington Mutual was taken over by Federal Deposit Insurance Corporation (FDIC) on 25th September, 2008 that transferred its assets to the bank of JPMorgan Chase. Wells Fargo took over Wachovia that was the fourth largest bank in October 2008. These upheavals in the financial institutions made the financial markets volatile. Industrial production declined, and investor confidence went down dramatically. Savings preference shifted to oil, the US dollar, and gold. The US Treasury bonds had close to zero returns with the financial markets constantly under significant pressures. The London Interbank Offer Rate (LIBOR) led to a further tightening of credit channels as its offer surpassed the interest generated by three-month treasury bills. LIBOR was also more than the three-month expected Fed Funds Rate (FFR). The economy faced increased credit risk with indications of fears of counterparty risk growth. Also, the real economy faced a blow when the commercial paper market was frozen to prevent the issuance of short-term debts by firms that they required for their continued operation. Credit restrictions impacted negatively on both consumers and firms. For instance, the US automobile industry was most affected as retail sales declined by about 31.9% in October compared to those of September 2008. The unemployment rate increased consecutively each month from 6.2% to 7.2% between September 2008 and January 2009 (Marshall 2009 p.7-8, Allen &Carletti 2009 p.11). Some problems coupled with complex financial instruments caused the transfer of financial problems from the housing sector into the financial system. First, poor risk analysis made it difficult to accommodate the housing bubble collapse. Secondly, credit ratings were not competitive enough and suffered from conflicts of interests and inadequate risk analysis. Thirdly, the regulatory bodies were inefficient to detect risks and effectively oversee credit rating and risk analysis. Lastly, the assurance of high profits with low risks increased the prevalence of risky loans in the financial markets (Marshall 2009 p.21-23). Transmission of Financial Crises to the Real Economy Allen &Carletti (2008 P.1) identified the various roles banks play in an economy. These roles include amelioration of information asymmetry between borrowers and investors, inter-temporal risk smoothening, insurance against unanticipated consumption shocks to the consumers, facilitating economic growth, and promoting proper corporate governance. As such banks and other financial institutions have a direct bearing on the performance of the real economy. If banks fail or collapse, the economy follows suit. Therefore, the financial crisis that made many banks collapse in 2007/2008 spread rapidly to affect the US real economy as well as the world economy. The uncertainty and financial losses caused by the financial crisis created hysteresis while the financial firms’ suspicion caused soaring of interbank lending rates. Depositors in an attempt to redeem their investments withdrew their deposits from banks. Banks became more uncertain and became reluctant to offer loans to other financial institutions whose creditworthiness was questionable. With increased interest rates, firms could not secure enough loans for investment. Hence, the credit crisis that ensued damaged the firms, reducing their production, and thus the real economy output declined,and the unemployment rate increased (Marshall 2009 p.25, Allen &Carletti 2009 p.9, Gros&Alcidi 2010 p.4). The effects of the financial crisis are felt long after the crisis with output and employment remaining at low levels for many years or several years after the crisis. Macroeconomic models account for the immediate effects of 2007/2008 financial crisis, but they do not explain why the financial frictions that cause low GDP and employment take years without healing (Hall 2010 p.3). The financial crisis of 2007/2008 impacted profoundly on the level of investment, but slightly affected other three GDPcomponents that include consumption, net exports, and government purchases. The latter three components of the GDP picked slightly after the crisis,but investment levels remained low for a long period. The bigger part of the decline in the U.S. economic output was associated with investment (Hall 2010 p.4). This can be explained by economic principles. The various components of investment are dependent on the financial markets as sources of finance especially residential investment. The investment and Savings are regulated by interest rates. When the interest rate is high, demand is low while when it is low especially during a recession, the demand is high. The Federal Reserve and the US Treasury intervened in the 2007 financial crisis to maintain equilibrium. The Treasury rate fell while the Federal Reserve bought billions of collateralized mortgage-backed bonds lowering the mortgage rate. The financial institutions, on the other hand, increased credit-rating requirements and the down-payment lowering the number of borrowers. This was out of the fear of the increased default rate (Hall 2010 p.5). The impact of the financial crisis of 2007/2008 was not immediately felt in the United States economy until late 2008 when the Lehman Brothers investment bank collapsed. Lehman Brothers was the leading financial institution not only in the US but also in the international financial market. Therefore, its collapse was not only felt in the US but also in the other economies all over the world. Investors left the financial markets while liquidity dried up. Economic activity in the US and many other countries fell drastically up to the first quarter of 2009 characterized by low unemployment rates and low output levels. The immediate effect was felt by the Western Europe economies and the United States economy, but the spillover of the financial crisis was powerful and soon its effects entered the international market(Terazi&Senel 2012 p.186). The crisis strained countries’ economic relationships especially between the US and China as many country debts increased due to increased trade deficits (Prasad 2009 p.224). The 2007/2008 financial crisis left behind feeble financial systems, low investment levels, high unemployment, and low production capacities all over the world. It was dubbed the worst financial crisis after the Great Depression (Allen &Carletti 2009 p.3). Conclusion The global financial crisis of 2007/2008 was occasioned by the deregulation that left financial systems to operate unrestricted. The financial crisis began in the United States’ housing industry as the real estate bubble and spilled over to the financial systems and later to the real economy. In the lending institutions, poor credit analysis, and limited credit control led to the issuance of loans to subprime borrowers who later defaulted causing a massive collapse of financial institutions due to bankruptcy. Financial systems are key players in an economy and their collapse impacted negatively on the real economy of the United States as well as other economies all over the world. The impact of the 2007/2008 financial crisis has been felt long after the crisis especially through low investment levels. Investment is the GDP component that is adversely affected by financial crisis with net exports, consumption, and government expenditure being affected for a short period especially immediately after the crisis. Low investment translates to low GDP and high unemployment rates. These are the tragedies that the financial crisis of 2007/2008 left behind in many world economies in addition to feeble financial systems, high country debts, and strained economic international relationships. References Allen, F. &Carletti, E. 2008. The Roles of Banks in Financial Systems, 1-30. Available at: http://fic.wharton.upenn.edu/fic/papers/08/0819.pdf [Accessed 11 December 2015]. Allen, F. &Carletti, E. 2009. The Global Financial Crises: Causes and Consequences, Journal of European Economic Association, 2, 1-44. Available at: http://www.bm.ust.hk/gmifc/Prof.%20Allen%20%26%20Carletti_The%20Global%20Financial%20Crisis.pdf [Accessed 11 December 2015]. BBC NEWS 2009.Credit Crunch to Downturn. [PDF] BBC NEWS. Available at: http://news.bbc.co.uk/2/hi/business/7521250.stm [Accessed 11 December 2015]. Gros, D. &Alcidi, C. 2010. The Impact of the Financial Crisis on the Real Economy, Inter-economics, 4-20. Available at: http://www.intereconomics.eu/downloads/getfile.php?id=719 [Accessed 11 December 2015]. Hall, R.E. 2010. Why Does the Economy Fall to Pieces after a Financial Crisis? Journal of Economic Perspectives, 24(4), 3-20. Available at: http://web.stanford.edu/~rehall/JEP%20paper.pdf [Accessed 11 December 2015]. Marshall, J. 2009. The Financial Crisis in the US: Key Events, Causes, and Responses, Library-House of Commons, Available at: http://www.voltairenet.org/IMG/pdf/US_Financial_Crisis.pdf [Accessed 11 December 2015]. Martin, C. &Milas, C. 2009. Causes of the Financial Crisis: An Assessment Using UK Data, The Rimini Centre for Economic Analysis. Available at: http://www.rcfea.org/RePEc/pdf/wp10_09.pdf [Accessed 11 December 2015]. National and International Issues 2015. The Financial Crisis 2007/2008 and its Impact on the UK and other Economies [PDF] National and International Issues, Available at: http://www.learnhigher.ac.uk/resources/files/business%20comm%20awareness/The%20Financial%20Crisis%20and%20its%20Impact%20on%20the%20UK%20and%20other%20Economies.pdf [Accessed 11 December 2015]. Prasad, E.S. 2009. Effects of the Financial Crisis on the U.S.-China Economic Relationship, Cato Journal, 29(2), 223-225. Available at: http://www.cato.org/pubs/journal/cj29n2/cj29n2-1.pdf [Accessed 11 December 2015]. Terazi, E. &Senel, S. 2012. The Effects of the Global Financial Crisis on the Central and Eastern European Countries, International Journal of Business and Social Science, 2(17), 186-192. Available at: http://www.ijbssnet.com/journals/Vol_2_No_17/25.pdf[ Accessed 11 December 2015]. Read More