Research Paper: Financial Crisis in the United States (2008)

Research Paper: Financial Crisis in the United States (2008)
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Research Paper: Research Paper: Financial Crisis in the United States (2008)
Introduction
The 2008 global financial crisis had a huge impact on the U.S. economy, posing numerous challenges whose magnitude had not been witnessed since the 1930s Great Depression. Numerous factors contributed to the crisis, including risky ventures by financial institutions, easy availability of unsustainable mortgages resulting in the housing boom, and rapid expansion of America’s financial system. These forces had been building up for several years, and they thus contributed to the crisis, which climaxed in 2008 September (Reyes, 2013). Huge financial institutions either collapsed, were forced to merge, or were bailed out from the government. Capital markets that enabled people to meet their daily needs were reluctant to give credit and investors lost trust in the country’s financial system. The federal government had to move with speed and implemented programs that would stabilize America’s financial system. This paper examines the cause of the 2008 financial crisis and the response of the U.S. government.
Causes – How it happened
The U.S. financial system was the main origin of the 2008 financial crisis since the interconnection, and the huge size of the country’s economy enhanced the contagion of the crisis, especially when Lehman Brothers were declared bankrupt. In comparison to the bank runs that occurred during the 1930s Great Depression, complex financial instruments that were difficult to re-price (Lin, 2009) facilitated the recent financial crisis. The financial instruments were internationally circulated in the balance sheets of different financial institutions. This provided an opportunity for developing new challenges of transmitting funds rapidly, and this financial boom was bound to collapse — this contribution to market instability, which was mainly caused by tremendous changes in creating new credit lines. It also limited the flow of money and reduced the rate of economic growth since people could hardly purchase or sell assets.
In mid-2007, the financial crisis started to unfold in America’s subprime mortgage market. Subprime loans are those loans that are advanced to risky borrowers at higher interest rates. Subprime loans started to play a central in the housing market since even with the increase in housing prices, there is still a huge boom in the housing demand. An increase in the prices of houses tends to reduce affordability, but subprime mortgages countered this through continuous relaxation of mortgage standards, thus ensuring the progress of the housing boom (Guina, 2018). The market instability hurt several people, business entities, and financial institutions, leaving most financial institutions holding mortgaged assets whose value had swiftly fallen. These assets did not bring the revenues that were required to advance new loans and even worse, the decline in the value of these assets led to the insolvency of these financial institutions.
Evidence also indicates that financial innovation that had occurred in the past whose aim was to minimize and diversify risks emerged as the main transmission strategy for instability. Therefore, the subprime mortgage crisis that was considered relatively small turned out to be a full-fledged financial crisis (Lin, 2009). The reserve cash of financial institutions dried up and this limited their credit and capacity to give out new loans. Few years before the crisis, easy access to cheap credit enabled individuals to purchase houses, take mortgages, and finance other investments that were based on pure speculations. Furthermore, cheap credit meant that there was increased money in supply which people were willing to spend. Regrettably, most individuals focused on purchasing the same product, which led to an increase in its demand, price, and led to inflation. Private equity institutions leveraged billions of dollars in debt, but firms and created wealth worth billions of dollars by only shuffling papers, and not making anything that was of value.
The most important issue to analyze is how things escalated to the point of forming a crisis. The first issue is greed. Since credit is the main factor that sustains the American economy, it has enabled people to live a better lifestyle. However, a decade before the crash, it remained unmonitored until things went out of control. For instance, mortgage brokers played the role of intermediaries, and after determining who would get the loans, the responsibility was passed to others regarding mortgage-backed assets (Ramskogler, 2015). Risky and exotic mortgages became common, and bad mortgages were repackaged and resold as investments. Most individuals took huge loans that they not could afford, and most brokers did not have any reason for refusing to sell loans since they were able to take their commission after the sale. Consequently, the assets that were backed by mortgages became ticking bombs that would later go off.
The decline in the housing market initiated a chain of reactions in the U.S. economy. Homes could no longer be sold for a quick profit, mortgages with adjustable rates became unaffordable, and a huge number of mortgage holders defaulted leaving financial institutions with valueless assets. Housing prices and building of new homes declined, thus pushing contractors and laborers out of the market (Ramskogler, 2015). Credit crunch implied that financial institutions were less willing to lend loans and they tightened the lending conditions. However, this was too late since the damage had already occurred. Financial institutions were either merged or acquired, the government bailed others out, and others collapsed.
Government Response
The U.S. government realized that things were getting out of hand in the financial market and it rushed to design an economic bailout plan that would eventually increase the flow of credit. The first action was to initiate broad-based guarantees of money market funds, bank accounts, and liquidity. However, this action was not enough, and the Federal Reserve discovered that there was a need for additional tools that had the capacity of addressing the increasingly worsening situation. The federal government thus created the Troubled Asset Relief Program (TARP), which enabled treasury to buy up to $700 billion worth of “troubled assets” from financial institutions that were at risk of collapse. $200 billion was injected in Freddie Mac and Fannie Mae to keep both institutions afloat, AIG was rescued with $112.5 billion, $29 billion to guarantee losses of Bear and Stearns, while $13.2 billion was for an FDIC takeover (Aikins, 2009). The bailout plan involved the implementation of the Emergency Economic Stabilization Act of 2008 and this was influenced by the deteriorating conditions in the financial market. The Treasury believes that it would be more efficient and faster to invest directly in the financial institutions compared to pu...