Causes of the Financial Crisis (Money on the Crisis Brittanica)

Causes of the Financial Crisis

Exact causes of the financial crisis debated among economists.
General agreement on factors contributing to the crisis but disagreement on their relative importance.

Anticipated a mild recession (post-2001) leading to a reduction of the federal funds rate, which is the interest rate banks charge each other for overnight loans of federal funds (balances held at a Federal Reserve bank).
Reduced the rate 11 times from May 2000 to December 2001.
- Federal funds rate: Decreased from 6.5% to 1.75%.
The significant decrease enabled banks to extend consumer credit at a lower prime rate, which is the interest rate banks charge to their low-risk customers.
- Prime rate: Generally 3 percentage points above the federal funds rate.
Encouraged lending to subprime customers at higher interest rates.
- Subprime lending: Lending to high-risk borrowers.
Resulted in consumers taking advantage of cheap credit to purchase durable goods, especially houses.
Created a housing bubble (a rapid increase in home prices beyond fundamental value due to excessive speculation).

Changes in banking laws since the 1980s enabled banks to offer subprime customers mortgage loans with:
- Balloon payments: Large payments due at or near the end of the loan period.
- Adjustable interest rates (ARMs): Rates that are fixed initially and then float with the federal funds rate.
As home prices increased, subprime borrowers could refinance their loans, protecting against high payments.
Subprime lending became lucrative for banks, leading to aggressive marketing of subprime loans.
Share of subprime mortgages increased from about 2.5% to nearly 15% of all home loans from the late 1990s to 2004-07.

Securitization: Practice where banks bundled subprime mortgages and less-risky debts to sell as securities (bonds).
Mortgage-Backed Securities (MBS): Securities entitling purchasers to a share of interest and principal payments on the underlying loans.
Banks used MBSs to increase liquidity and reduce exposure to risky loans. Investors viewed them as a means of portfolio diversification and profit generation.
MBS popularity soared with rising home prices in the early 2000s.

Repeal of the Glass-Steagall Act (1999) allowed financial institutions to enter each other's markets, resulting in "too big to fail" institutions.
The SEC weakened the net-capital requirement in 2004, encouraging banks to invest heavily in MBSs.
This investment practice led to significant risk since MBS values depended on the housing bubble.

The Great Moderation: A long period of global economic stability from the mid- to late-1980s led to complacency among financial executives, government officials, and economists.
Confidence in financial self-regulation ignored signs of crisis, leading to reckless lending and securitization.

From June 2004 to June 2006, the Federal Reserve raised the federal funds rate from 1.25% to 5.25%, leading to defaults among subprime mortgage holders with ARMs.
Home sales and prices began to decline in 2005 as subprime borrowers became "underwater" (owed more than their homes were worth).
Value of MBSs declined affecting banks and investment firms.

MBSs linked to U.S. housing were traded worldwide, indicating that issues in the U.S. posed global risks.
In 2007, significant losses hit banks, hedge funds, and other financial entities leading to bankruptcies and government appeals for loans.
MBSs became classified as "toxic" assets, leading to severe financial instability.

By April 2007, New Century Financial went bankrupt and many lenders halted operations. Banks ceased lending to subprime customers, worsening the housing market.
Global banks, such as BNP Paribas, reported massive losses; American Home Mortgage declared bankruptcy in August 2007.

Difficulty in assessing MBS values created distrust among banks, leading to a freeze in lending.
The Federal Reserve began purchasing federal funds to provide liquidity to banks in early August 2007.
Fed cut the federal funds rate three times from 5.25% to 4.25% (September to December 2007).
Northern Rock, a UK lender, ran out of liquid assets prompting a government loan and nationalization.

In January 2008, Bank of America acquired Countrywide Financial amidst severe losses in the financial sector.
Bear Stearns was purchased by JPMorgan Chase with the Fed covering $30 billion in risky assets.
Federal Reserve continued lowering the federal funds rate (4.25% to 2% between January and April 2008).
Fannie Mae and Freddie Mac faced bankruptcy due to the rise of subprime mortgages and Government nationalization occurred in September 2008, covering approximately $1.6 trillion in debts.

Lehman Brothers' bankruptcy in September 2008, with $639 billion in assets, marked the largest bankruptcy in U.S. history and escalated turmoil in financial markets.
Treasury Department refused to intervene in Lehman's case citing "moral hazard" but later approved government assistance for AIG due to its systemic importance.
Other financial institutions faced collapse or were seized in the weeks following.

Proposal of the Emergency Economic Stabilization Act (EESA) included the Troubled Asset Relief Program (TARP) to purchase troubled assets.
TARP faced initial rejection but was modified and passed and signed into law in October 2008.
The government used TARP funds to purchase preferred stock in banks, leading to federal ownership in over 200 institutions by the end of 2008.

The Federal Reserve endorsed several QE programs to tackle liquidity issues, which involved extensive asset purchases to stimulate growth.
By 2014, QE measures pumped over $4 trillion into the U.S. economy.

Recovery was supported by the American Recovery and Reinvestment Act (2009) with a $787 billion rescue and stimulus package.
Financial markets stabilized and economic growth resumed by mid-2009, but the job recovery was slow and characterized by lower-paying employment.

Estimated $17 trillion net worth loss (adjusted for inflation) for American households; a 26% decline.
Gross domestic product (GDP) loss was approximately 7% lower than it would have been without the crisis, translating to a lifetime income loss of $70,000 per person.
7.5 million jobs lost (doubling of unemployment to nearly 10% by 2010); slow recovery reduced unemployment to 3.9% by 2018.
Disparity in recovery: Executives rebounded faster, some with bonuses despite their role in the crisis, while ordinary Americans struggled.

Rising economic inequality led to public resentment and the emergence of the Occupy Wall Street movement in 2011.
Movement focused on the disparity between the top 1% and the 99%, raising awareness but lacking concrete goals for reform.

The combined response of Fed intervention and legislation post-crisis helped stabilize the U.S. financial system albeit amid significant social and economic inequality post-crisis.