Between 2008 and 2009, the United States and countries all over the world suffered one of the most impactful financial market collapses in the 20th and 21st Centuries. In the United States, what had started as a deep dampening of prices of new houses in 2007 quickly turned into an almost full collapse of the financial market as investors rushed to offload their investments in mortgage-backed securities (Merle, 2018). To the American public, the crisis was unprecedented and caused millions of people to lose their houses because they could not afford to pay interest on their mortgages. The government reacted in its usual predictable manner by saving big banks, which were considered “too big to fail” while leaving millions of Americans to their devices. What followed was an investigation of the genesis of the crisis, which revealed that catastrophic failure in oversight, the systemic weakening of usury laws, and outright thuggery by banks and mortgage salespeople were the major causes of the 2008-2009 financial collapse.
Between the 1990s and early 2000s, usury regulations were systemically weakened, which made it possible to issue borrowers whose capacity to repay was questionable. As mortgages became widely available for virtually anyone who wanted one, demand for new houses rose, which led to a significant increase in house prices. Keen to make as much money as possible, investment banks devised a product they called mortgage-backed security, where they would buy mortgages from banks, bundle them and sell them in the security markets. The higher returns and the security underlying MBS made them more attractive to investors leading to their increased demand. To satisfy this demand, banks issued more sub-prime loans as they could use the cash from selling their interest in a mortgage to lend to other borrowers. In 2007, the supply of new houses started exceeding the demand, and interest rates on mortgages increased, leading to mass defaults and a supply glut that significantly impacted the prices of real estate in the United States (Milas, 2021). Thus, the weakening of usury laws by successive administrations made it impossible to offer adequate oversight.
Falling housing prices and increasing defaults meant that the value of underlying security for all mortgage-backed securities fell significantly and a guarantee for monthly payments was in danger. Investors reacted to this prospect by dumping mortgage-backed securities, which led major banks and investment banks with massive long positions on MBS to declare bankruptcy (NĂĽtzenadel, 2020). The declaration of bankruptcies by large organizations exacerbated market fears, which would later blow up into a full financial meltdown that spread to all sectors of the United States economy. To minimize the damage to the economy, the outgoing government of President Bush and the incoming government of President Obama pushed massive subsidies through Congress. However, the damage was already done; several large and small corporations, such as Lehman Brothers, could not be saved while millions of homes were foreclosed by the banks.
The free market failed to avoid this eventuality because of the demand for mortgage-backed securities. The markets respond to forces of demand and supply. At the time, MBSs were in high demand because of their supposed low risks and high returns. Consequently, there were willing buyers and sellers of MBS. With high demand and supply in the financial market, there were limited actions that could have occurred to rattle the free market to rein trading in MBS. In addition, as long as trading in these securities was legal, the free market could do nothing but facilitate their trade.
In addition, market realities directly contributed to this catastrophe. Firstly, investors who were supposed to have done due diligence on the value and feasibility of the underlying MBS security failed to do so (NĂĽtzenadel, 2020). This failure meant that subprime mortgages issued to purchase overpriced houses were a ticking time bomb that detonated once house prices started going down. Secondly, an information asymmetry existed among the various players in the issuance of mortgages at the time. Specifically, mortgage salespeople lured borrowers with a promise of low and affordable interest rates. However, they failed to disclose that the adjustable-rate mortgages issued to customers would reset after some time, making principal and interest rate payments unsustainable or unaffordable (Yazdanfar & Ă–hman, 2020). Thus, the push by all market players to benefit from the housing boom neglected market realities, which directly contributed to the 2008-2009 financial crisis.
The regulator and consumers could not avert the financial crisis of 2008 to 2009. A systematic weakening of usury laws in the 1990s and early 2000 meant that the regulator had little authority to rein the various players in the market (Yazdanfar & Öhman, 2020). As financial institutions and institutional investors took large and unprecedented risks, the regulator was powerless to stop them. In addition, the regulator’s focus was on institutional risks rather than the systemic risks inherent in mortgage-backed securities. Further, the regulator did not require adequate disclosure on financial derivatives positions, which proved to be fatal because they produced externalities that doomed individual firms. The consumers also contributed to this catastrophe and could thus not stop it. Consequently, the borrowers’ quest to own a house while paying negligible interest rates drove them to take adjusted-rate mortgages, guaranteeing that the least financially capable would default once the interest reset after some time.
References
Merle, R. (2018). A guide to the financial crisis – 10 years later. The Washington Post. Web.
Milas, C. (2021). From the 2008-2009 financial crisis to the COVID-19 pandemic: Challenges and the way forward.SSRN Electronic Journal. Web.
Nützenadel, A. (2020). The financial crisis of 2008—experience, memory, history.Journal of Modern European History, 19(1), 3–7. Web.
Yazdanfar, D., & Öhman, P. (2020). The 2008–2009 Global Financial Crisis and the cost of debt capital among SMEs: Swedish evidence.Journal of Economic Studies, 48(6), 1097–1110. Web.