Scott Johnson
Dr. Kerr
EN101-12
13 May 2013
Could
the 2008 Financial Crisis Have Been Avoided?
The 2008 to 2009
financial crisis was a catastrophe so devastating it triggered a recession.
This crisis is still fresh in people’s minds as everyone, rich or poor, felt
its impact. The crisis resulted in many alarming events during the financial
meltdown, such as the government’s 700 billion dollar bailout to the some of
the nation’s largest financial companies that went bankrupt like Fannie Mae and
AIG in 2008, or the stock price drop of banking giant, Citigroup, from 60
dollars a share to 97 cents a share in 2009 (Amadeo; Lenzner). Even though this
economic mayhem resulted from the immediate crisis, factors that helped lead to
the crisis began contributing to the problem years before it occurred.
According to the article “Causes of Economic Recession”, it all started when
the Fed began lowering interest rates in 2001 in response to the recent
recession caused by the decrease in technology and dot com stocks. By 2004 the
economy had recovered enough to the point where it started to boom again.
Interest rates are usually increased in times of economic boom, but the rates
were kept low in 2004 and in 2005. This is one factor that added to the
irrational exuberance in the housing market (Amadeo). With help from low
interest rates, lending standards were lowered and lowered until people with no
proof of income, no assets, and no job were able to get large mortgages for no
money down (Montana). This is where the problem of subprime mortgages began,
which are high risk home loans where the person paying the loan has bad credit
(“recession”). In the article “What caused the great recession of 2008-2009?”,
Sam Montana explains that because it was so easy for people with bad credit to
get mortgages, there was a big increase in subprime mortgages and an irrational
exuberance in the housing market began to emerge. Banks were looking to make
money and began selling mortgage backed securities. Mortgages in a certain area
were put together and then sold to investors in pieces, but the credit
worthiness of each mortgage in the group was unknown to the investors. This
unregulated, risky type of mortgage backed security is called a collateralized
debt obligation or CDO. Because of the growing housing bubble at the time,
there was a large demand for these CDO’s. The major problem with these CDO’s is
that the banks had an alarming leverage of thirty to one, which meant that for
every one dollar of their own money they invested, they also invested thirty
dollars of borrowed money (Montana). Eventually, the large amount of subprime
mortgages began to take a toll on the economy when the housing bubble burst in
2006 (Amadeo). Many of the homeowners with subprime mortgages began to
foreclose when they fell behind or couldn’t make payments (“recession”). As a
huge amount of homeowners began to foreclose, banks and hedge funds with a
large amount of mortgage-backed securities began to panic because they were
facing huge losses (Amadeo). Some banks had been reporting CDO’s with inflated
prices in their books because of the housing bubble, but when it burst and many
began to foreclose the actual value of the CDO’s began to drop dramatically
(Montana). Because the financial industry and banks are interconnected and lend
to each other, all felt the impact and suffered losses even if they didn’t own
any mortgage backed securities (“recession”). By the summer of 2007, banks were
afraid to lend to each other because of the impact of the toxic mortgage backed
securities (Amadeo). The financial situation continued to worsen until it
became a full blown crisis by 2008. In the summer of 2008, two of the nation’s
biggest finance companies, Fannie Mae and Freddie Mac, were on the verge of
collapse because of their exposure to mortgage backed securities (“Recession”).
The government then took control of the two companies as it extended a 300
billion dollar credit line to stabilize them. It was only ten days later that
the international finance company, Lehman Brothers, declared bankruptcy, which
was the largest bankruptcy in U.S. history. Days after, the federal government
authorized the buyout of insurance giant, A.I.G., for 85 billion dollars.
Larger banks that had not gone bankrupt struggled to stay in business and were
forced to completely restructure, such as Citigroup and Merrill Lynch. Smaller
financial institutions also suffered as many went bankrupt or sought government
bailouts for economic security (“recession”). The economy was so damaged by the
crisis the government was forced to step in even further with the Troubled
Asset Relief Program in October 2008, which authorized 700 billion dollars in
rescue funds for suffering banking firms (“recession”). By December 2008 It was
obvious a recession had already started, but to make matters worse, employment
was falling faster than It had during the 2001 recession (“Amadeo”). This
financial crisis sent the economy tail spinning into a recession, but one is
forced to wonder if something could have done something to prevent it. The 2008
financial crisis could have been avoided if the Federal Reserve had better
regulated new financial instruments, if the government hadn’t kept interest
rates and lending standards so low, and if finance companies hadn’t taken on a
large amount of risky securities.
The major cause
for the 2008 recession was massive deregulation by the government because they
failed to notice the risky actions being taken by financial institutions. According
to the New York Federal Reserve website, the entire Federal Reserve System works
to “Foster the safety, soundness and vitality of our economic and financial
systems”. The same website also lists “supervising and regulating depository
institutions” as one of their major responsibilities. This means that it is a
responsibility of the Federal Reserve to regulate banks and the actions they
take. The Federal Reserve should have seen the risky moves by banks and
prevented the toxic mortgage back securities (Chan). The Financial Crisis
Inquiry Commission states that, “The 2008 financial crisis was an “avoidable”
disaster caused by widespread failures in government regulation” (Chan). The Federal
Reserve is responsible for regulating and reacting to bank’s actions (“What We
Do”). Because toxic mortgages were a major cause of the crisis, then the
financial crisis could have been prevented had the Federal Reserve better
regulated banking firms. The Financial Crisis Inquiry Commission goes further into
detail, criticizing “the Federal Reserve and other regulators for permitting a
calamitous concoction: shoddy mortgage lending, the excessive packaging and
sale of loans to investors and risky bets on securities backed by the loans”. The
Commission finds Alan Greenspan, who was the Federal Reserve chairman before
and during the financial crisis, mostly at fault because he advocated
deregulation. Greenspan is also criticized by the commission for a “pivotal
failure to stem the flow of toxic mortgages” and says that he is an example of
negligent leadership (chan). Economist and Nobel Laureate, Paul Krugman, notes
that Federal Regulation did not keep with the system, especially because of new
unsupervised financial instruments, like the collateralized debt obligations
that ruined many large finance companies (Weisburg). In the article “The credit
bubble, the recession and what the Federal Reserve should have done”, the
author states that there were many warnings of a housing bubble collapse that the
Federal Reserve should have heeded, but they did not because of the policies of
deregulation advocated by the federal Reserve chairman during the crisis, Alan
Greenspan, and his successor, Ben Bernanke (Lowenstein).
Low interest
rates, due to the 2001 recession, led to lowered lending standards, which
caused the housing bubble to grow until it peaked in 2008. According to the
article “Causes of Economic Recession”, the 2001 recession plays a role in the
2008 financial crisis because it is the reason interest rates were so low
around 2005 and after. The 2001 recession was similar to the 2008 financial
crisis because it was caused by irrational exuberance in the tech market rather
than the housing market. When recession hit in late 2000, the Federal Reserve
began to lower interest rates by half a point each month until they were as low
as 1.75 percent in December of 2001. High interest rates can cause recession because
they limit liquidity, so they need to be lowered so that lending standards will
also be lowered, which makes it possible for small businesses to get loans. However,
when the economy began to pick up again in 2004, the Federal Reserve did not
raise interest rates to match. When the economy had picked up even more in
2005, low interest rates allowed people to get loans on houses they couldn’t afford.
This led to the irrational exuberance in the housing market and, subsequently, the
housing bubble collapse (Amadeo). Analysts of the 2008 financial crisis
continue to find Federal Reserve chairman, Alan Greenspan, at fault because he kept
keeping interest rates too low between 2003 and 2005 as the housing and credit
bubbles inflated (Weisburg). While it is impossible to know for sure, Banks may
not have made so many questionable loans had the Federal Reserve raised
interest rates around 2004 and 2005 because lending standards would not have
been so low (Lowenstein).
Even though all
financial institutions felt the impact of the recession, the few that went
under lost because they unwisely bought large amounts of mortgage backed
securities that were extremely risky. Even though the Federal Reserve and other
agencies regulate the financial industry, financial companies themselves are
responsible for their own actions. In its report, the Financial Crisis Inquiry
Commission documents that many mortgage lenders’ practices were questionable and
that banks were making careless bets on securities; however, the commission focuses
on the pure incompetence of many large finance firms. The commission’s report
quotes executives from Citigroup admitting that they did not pay attention to their
mortgage related risk and explains that “Executives at the American
International Group were found to have been blind to its $79 billion exposure
to credit-default swaps, a kind of insurance that was sold to investors seeking
protection against a drop in the value of securities backed by home loans”. Managers
of the banking firm, Merrill Lynch, also admitted to being surprised when the
mortgage investments, that appeared to be secure, started suffering huge losses
(Chan). Furthermore, Mortgage companies that allowed the subprime loans were
not concerned because they sold most of the mortgages they wrote, so they wouldn’t
be in any trouble if the mortgage defaulted (Montana).
Those who
believe that the financial crisis of 2008 was unavoidable base their argument
on the policies and actions of Alan Greenspan, the Federal Reserve chairman
during the crisis. In his article “The Financial Crisis Could Not Have Been
Prevented”, Economist, Robert Lenzner, explains that Alan Greenspan was in
control of monetary policy for 18 years, but that Greenspan personally felt
that deregulation was best for the financial industry. Despite being warned
about the easy money policies, he continued deregulation and failed to notice
the numerous toxic mortgages because of it (Lenzner). The opposing view is
arguing that Greenspan was the only one who had the power to prevent the
crisis, but he made no attempt to do so, even after he was warned; therefore,
the crisis was unavoidable because nothing would have swayed Greenspan against
his policy of deregulation. This argument is valid in that Greenspan was warned
about deregulation, but still did not change his policy. The fault with this
argument lies in that, Even though Greenspan was in control of the Federal
Reserve as its chairman, he is just one man who could not have denied dangers
of a flooding of subprime mortgages into the financial system had the entire Federal
Reserve watched banks more closely. Greenspan may have advocated deregulation
and gave banks more freedom than they should have had, but the hazardous amount
of toxic mortgages should not have gone unnoticed by the Federal Reserve, a
regulatory agency with responsibilities that include reacting to bank’s actions
and fostering the soundness of the nation’s economy (“What We Do”). Robert
Lenzner is saying that because Greenspan didn’t take action to prevent the
crisis, he would never have prevented the crisis; however, Greenspan and the
Federal Reserve as a whole, could have prevented the crisis, had they paid more
attention to banks and investment firms.
The financial
crisis of 2008 wrecked the economy, impacting everyone due to the some of the largest
banking firm collapses in history. When one wonders if the crisis could have
been avoided, it is important to understand exactly what happened and what
could have been done. Government agencies, like the Federal Reserve, have been
under fire because of its failure to notice the dangerous actions of banks it
is supposed to regulate (Chan). The companies like Bear Stearns and Lehman
brothers are also at fault themselves for failing to notice their own dangerous
levels of risk. Placing blame does not determine whether the crisis was
avoidable, but if the government agencies and companies responsible acted more wisely,
the crisis would not have occurred. The Financial Crisis Inquiry Commission
explains that “The greatest tragedy would be to accept the refrain that no one
could have seen this coming and thus nothing could have been done...If we
accept this notion, it will happen again” (Chan).
Works
Cited
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Weisburg, Jacob. "What Caused the Economic
Crisis."Slate.com. Slate group, LLC., 09 Jan 2010. Web. 27 Apr
2013. <http://www.slate.com/articles/news_and_politics/the_big_idea/2010/01/what_caused_the_economic_crisis.html.>
"Recession." American Decades: 2000-2009.
Ed. Eric Bargeron and James F. Tidd, Jr. Detroit: Gale, 2011. 221-223. Gale
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Montana, Sam. "What caused the great recession
of 2008-2009?." Knoji.com. Social Commerce Labs., 26 Apr 2013.
Web. 27 Apr 2013. <http://economics-the-economy.knoji.com/what-caused-the-great-recession-of-20082009/>.
Lenzner, Robert. "The Financial Crisis Could
Not Have Been Prevented." Forbes.com. Forbes.com LLC, 29 Jan
2011. Web. 7 May 2013.
<http://www.forbes.com/sites/robertlenzner/2011/01/29/heres-why-the-financial-crisis-could-not-have-been-prevented/2/>.
Lowenstein, Roger. "The credit bubble, the
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The Washington Post, 02 May 2010. Web. 10 May 2013.
<http://www.washingtonpost.com/wp-dyn/content/article/2010/04/30/AR2010043001103.html>.
"What We Do." newyorkfed.org.
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