Essay writings on 2008 Credit Crisis

Credit Crisis 2008

            By looking at the U.S. financial crisis in 2008, this economic disaster is the worst since the 1930’s Great Depression and it could have been worse regardless of the Federal Reserve and Treasury Department's power to prevent the financial crisis. The credit crisis that happened in 2008 has led to the great recession of the housing price dropped significantly in the U.S. It all started when American citizens wanted to buy a house and would take a loan from the Bank. People would borrow hundreds of thousands of dollars from a bank which in return, the bank gets a piece of paper called a mortgage. Every month, people that bought the house with a mortgage had to pay a portion of the principle with additional interest. If they are unable to pay or stop paying for the mortgage, it’s called a default. The borrower pays the principal and interest to those who hold the mortgage paper, in this case, not just a bank. Banks often sell the mortgage to some third party, which is the start of the cause of the credit crisis in 2008. Generally, a mortgage was tolerably hard to get if people had bad credit or didn’t have a steady job. It was simply because the lenders don’t want to take the risk that people with those categories might fall on default on the loan. The idea is that the mortgage is only given to prime mortgage or in other words people with good credit.

            Started in the year 2000s, the investors started looking for a low risk and high return investment and they hold the attention of the U.S. housing market. The thought was they could get a high return from the interest rates from the mortgages of the homeowners better than investing in treasury bonds which were paying low on interest. The investors bought investments called Mortgage Backed-Securities. Mortgage Backed-Securities created when the large financial institutions securitize mortgages by buying up thousands of individual mortgages, bundled together, and sell shares of that pool to investors. It results in attention drawing to the massive investors because the rate of return is higher than any other type of investment. Later the home prices were rising significantly, and the lenders thought that borrowers could default on the mortgage, and then they could resell the house for more money and new mortgage. Meanwhile, the credit rating agencies were telling investors that these Mortgage backed-securities were a safe investment. The credit rating agencies also gave those Mortgage backed-securities AAA ratings which were the best of the best since the mortgages were only for borrowers with good credit, mortgage debt was indeed a good investment at the time.

            Investors were really into this type of investment and since there is more and more demand for this investment, lenders needed more mortgage. But to get more mortgage, they needed more new homeowners borrowing money and paying a mortgage. Hence, the lenders ease the standards, and loans were granted to people with subprime mortgages. In this case, subprime mortgages were those that fall on low income and bad credit history. Some financial institutions started the term Predatory Ending Practices to generate mortgages. The loans were given to people without verifying the income and financial condition of the borrower, and the mortgage rate was given at the small amount at first but quickly inflate beyond their means. These predatory lending practices were brand new and credit rating agencies still indicated that this is a type of mortgage investment that’s safe by looking at the historical data although it’s not. These practices were becoming less safe as time goes on. Despite the higher risk, investors trusted the ratings and kept investing their money. Traders also started selling a riskier product called collateralized debt obligations, CDOs in short. And these investments were given the highest credit ratings from the rating agencies which made investors invested more and more.

            While investors and traders were investing in these housing market, the U.S. price of homes was growing more and more. The new weak lending requirements and low-interest rates drove housing prices higher, which only made the Mortgage Backed-Securities and CDOs seem like a better investment. Since the housing prices getting more and more expensive, it occurred to be a housing bubble. The housing bubble happened when people couldn’t afford their expensive houses or keeping up with the rising mortgage payments. Borrowers started defaulting, which put more houses on the market for sale. But there weren’t any buyers. So supply rose and the demand went down, thus the home prices started collapsing. As prices fell, some borrowers automatically had a mortgage for more than their home was currently worth. People stopped paying mortgages because of that, and ended up to more defaults, pushing prices down further.

            At the same time, big financial institutions stopped buying subprime mortgages and subprime lenders got stuck with bad loans. By 2007, some lenders even had declared bankruptcy. Investors started losing money on Mortgage backed-securities and CDOs. The problem was made worse with another financial instrument that selling unregulated derivatives one of which is the credit default swaps that were basically sold as insurance against mortgage-backed securities. American International Group (AIG) was one of the financial institutions that sold insurance against Mortgage backed-securities, without money to back them up just in case things went wrong. And as a result, things went wrong and AIG didn’t have the money to back them up. Panic started happening, trading and credit markets froze, the stock market crashed. And the U.S. economy ended itself in a recession and the issues arose in 2008.

            In order to fight the recession, the Federal Reserve offered to make emergency loans to the bank. It was to prevent fundamentally sound banks from collapsing because of lenders panicking. The government executes the Troubled Assets Relief Program (TARP) which is in other terms as Bank Bailout. This was originally allocated $700 billion to prop up banks. It actually ended up spending $250 billion bailing out the banks and the others were later expanded to help auto companies, AIG, and homeowners. In combination with lending by the Fed, this helped stop the panic in the financial system.

            In 2009, President Barack Obama asked Congress for an economic stimulus package. Instead of using the remaining $700 billion allocated for TARP. This helped slow the free fall of spending, output, and employment at that time. Congress has also passed financial reform, called the Dodd-Frank Wall Street Reform Act in 2010. It was to increase transparency, prevent banks from taking on too much risk, and it allows the Fed to reduce the bank size for those that become too big to fail.