Financial Crisis 2007-09

Coursework for EC1013A

The Global Economy

“Analyse the Causes and Consequences of the Great Recession of 2007-2009.”


Introduction:


The Great Recession of 07-09 is considered by many pundits as the worst crisis since the Great Depression in 1930 (Business Wire News, 2009)[i]. One of the main problems which started this situation was the US banking system, which has been badlypromoted by the previous governments (Bush, Clinton) and ended up with a liquidity shortfall (Bloomberg, 2010)[ii]. This fact resulted in bail-outs, bankrupts, financial institutions collapsed and a decline of the economic activity (M. Baily & D. Elliot, 2009)[iii]. In 2006 the real estate bubble burst in the US and provoked in 2007 the crisis of the subprime mortgages.
Anyway there are many causesfor the financial crisis but the most significant risks remain for all economies in the world.





Causes:

As I said before there are a lot of causes but here I will try to explain briefly some of the major causes that contributed to the great recession.

The growth of the housing bubble, it has been growing without stop since 1997 until 2006, inflating house prices (The economist,2007)[iv]. Until the bubble exploded banks were lending money to potential home owners, and each time they provided higher quantities of money to a higher number of people with the confidence that owners will be able to pay back. It was so easy to obtain any kind of loan (mortgage, credit card and auto) that consumers assumed an unprecedented debt loan (Krugman, 2009)[v]. Banks offered easy creditconditions which hidden a large contract that may change them, the sub-prime lending increased in the US thanks to the pressure of the government on Fannie Mae & Freddie Mac (Government sponsored enterprise which owned 50% of the mortgages in the US) to expand mortgages loans among low a moderate income people (The New York Times critics to Clinton government).

We can traduce these facts in:predatory lending, it refers to the practice of unscrupulous lenders to enter into unsafe secured loans for inappropriate purposes[vi]. For example Countrywide Financial (Bank of America Home Loans) advertised 1 or 1.5 % interests rates in an adjustable rate mortgage (ARM), so the interest charged would be greater than the amount of interest paid, creating a negative amortization. If we accompany thepredatory lending with the lack of regulatory framework for the financial innovation it turns into off-balance sheet financing.

The “financial innovation” (creating and marketing new types of securities) the term refers to the development of financial products design to achieve particular client objectives: ARM (adjustable rate mortgage), MBS´s (mortgage-backed securities) CDO´s (collateralizeddebt obligations) and CDS (credit default swap) all these new products took an important role within the financial crisis. MBS and CDO are the bundling of subprime mortgages for sale to investors. This innovation was pretended to reduce the risk through diversification, but Warren Buffet (American Investor) and Raghuram Rajam (IMF chief economist) warned that these types of ABS´s (structuredasset-backed security) spread risk over the market and uncertainty about the value of the underlying assets.
The use of these products expanded dramatically before the crisis but market participants didn´t measure exactly the risk associated to them or/and didn´t understand its impact on the overall stability of the financial market.

Now international financial firms were able to invest in the USmarket. The problem got bigger as ABS´s were positively rated by credit rating agencies, furthermore ABS don´t have a specific regulation so vendors don´t need to set aside reserves in case of default, thereby increasing their profitability.

Firms from all over the world invested in these toxic assets ignoring the real risk that they were taking.
We can see it better with an example about...