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Features of the U.S. Financial System That Caused the Great Recession of 2007-2008

Updated on April 11, 2017

There are three main factors of the U.S. financial system that facilitated the Great Recession; they are financial innovation in mortgage markets, agency problems in mortgage markets, and the role of asymmetric information in the credit-rating process.

How the Recession Started

A series of ill-fated activities occurred to allow a long run of inefficiencies in the American financial system’s ability to weed out undesirable borrowers. According to Mishkin (2015) the introduction of the FICO score, a numerical value that weighs the risk of default, as well as a reduction in transaction costs, made possible by improved technology which gave financial intermediaries the ability to group small loans into standard debt securities. This process is known as securitization, and it allowed banks to offer subprime mortgages to high-risk borrowers.

A moral hazard persisted when these high-risk loans were seamlessly bundled into standardized debt securities called mortgage-backed securities. Furthermore, financial intermediaries offered structured credit products, the most famous of these being the collateralized debt obligations (CDO’s). According to Mishkin (2015), structured credit products like CDO’s appealed to investors and became the dark financial instrument used to secure financing for millions of adverse mortgages. The Former Federal Reserve Chairman, Ben Bernanke, explained in a 2010 speech that the causes of the Great Recession of 2007-2008 cannot be leveled at the government’s feet. Instead, the blame must be placed upon the uncontrolled and explosive growth of innovative mortgage products that affected mortgage payments, lending standards and a proliferation of capital from foreign countries. These factors worsened asymmetric information. And this toxic combination led to the housing market boom and bust at which point financial institutions were too entrenched in these hazardous practices to insulate themselves and several went bankrupt while survivors went into panic mode and no one quite understood what went wrong.

Institutional and Systemic Changes May Have Prevented The Financial Crisis

In 2015, a New York Times article by Neil Irwin cited that keyword searches for “housing bubble” peaked in 2005 and in that same year over 1600 major world publications carried articles that used the term “housing bubble.” Therefore sufficient concern should have caused closer monitoring and regulation. Even without greater regulation financial intermediaries should have been more prudent. The markets would have continued to run efficiently if high-risk mortgages were not advertised as safe bets. The institutional and systemic correction to this problem would have been to separate the credit-rating agencies from the engineering and structuring of financial instruments such as CDO’s.

The Bull And Bear Market Watch

The banks contributed to such inefficiency in the housing market  interfering with the dynamics of the bull and bear counteractions so much so that the markets were unable to cool off and make a soft landing.
The banks contributed to such inefficiency in the housing market interfering with the dynamics of the bull and bear counteractions so much so that the markets were unable to cool off and make a soft landing.

How Financial Institutions Responded to The Crisis

Financial institutions were reactive rather than proactive. They had backed large volumes of liabilities with no sensible methods of achieving liquidity in order to make payments in the case of default. I imagine no one bothered to formulate a contingency plan since the assumption was we are “too big to fail.” Banks exhibited a follow the leader strategy which caused groupthink. The rank and file leaned on the decision making of big banks for a measure of sound financial practice, and when the big banks went belly up, they all froze. According to Mishkin (2015), panic-stricken financial institutions engaged in fire sales which led to a rapid decline in asset values resulting in a deleveraging of firms and a turn down in economic activity.

The Feds Should Have Seen it Coming

Foresight could have prevented the crisis altogether. CDO’s and similar financial instruments should have been regulated. Instead of an unprecedented bail-out, a conservatorship type take-over would have likely prevented the massive loss in value of assets and would have directly reduced situations of moral hazard that protracted the crisis. As a matter of fact, Fannie Mae and Freddie Mac by September 2008 were in effect ran by the government. (Mishkin, 2015)

Agency Problems Played A Big Part In The Financial Crisis

Colusion-like behavior between financial intermediaries and credit reporting agencies made the markets inefficient
Colusion-like behavior between financial intermediaries and credit reporting agencies made the markets inefficient

The Market Sectors and Financial Institutions Lack of Answers

Financial intermediaries need to do everything in their power to reduce asymmetric information. Monitoring and enforcing restrictive covenants could have prevented some features that caused the crisis. For example, requiring subprime mortgages to be issued only to primary residents of the property the loan was being established on would have prevented high-risk borrowers from acquiring more than one piece of property. Also, Matthew C. Plosser in 2014 presented research findings to the New York Federal Reserve Bank indicating that because of the diverse mix of banks in the U.S. economy, capital may have been confined inside insulated, less risk tolerant banks during the crisis. (Plosser, 2015) This suggests that financing options from several small banks perhaps from the most isolated places in America could have minimized the crisis. The big companies balance sheets could have remained intact and pensions, mutual funds, and asset values would have been spared if they shopped around during their need for liquidity.

The Feds Need to Be Agile

The credit-ratings agencies mishandling of bonds ratings, zero-down mortgages, and other features of the crisis that were plagued with agency and moral hazard problems proves regulation has to be present, always vigilant and has to be proactive. Regulation also has to be dynamic; it must be able to both tighten and relax at will. Mishkin (2015) gives the example of Regulation Q which up until 1986 gave the government the power to impose restrictions on interest rates paid on deposits. The purpose of this regulation was debunked, and it was thereby abolished. Dynamic regulation means the process whereby the efficacy of a particular regulation is proven must be streamlined.

The Ten-Year Forecast for The U.S. Economy

The Trump administration set goals for a 2-3% GDP growth and billionaire, David Tepper, told CNBC that this is a modest expectation (Belvedere, 2017). I believe more savers than borrowers with opportunities for productivity will cause the equity market to continue its bull run. Unemployment will remain at or near current levels as more people seek to reenter the labor force. Oil prices will remain stable as America pursues energy independence. Several small and natural housing market corrections will occur to level things off. Inflation will rise due to student loan pressures. If not propped up by the government, the student loan bubble will burst, and tuition rates will tumble, private colleges will fail by the droves.

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References

Belvedere, M. (2017). Economy can grow in 3% range with no surprises from Trump or Congress, Tepper says. CNBC. Retrieved 9 March 2017, from http://www.cnbc.com/2017/03/08/david-tepper-i-dont-see-a-downside-for-business-from-trump-and-gop-congress.html

Irwin, N. (2015, December 23). What ‘The Big Short’ Gets Right, and Wrong, About the Housing Bubble. Nytimes.com. Retrieved 7 March 2017, from https://www.nytimes.com/2015/12/23/upshot/what-the-big-short-gets-right-and-wrong-about-the-housing-bubble.html?_r=0

Mishkin, E. (2015). Financial Markets and Institutions. Pearson.

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    • Angelo Grant profile image
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      Angelo 5 months ago from New Castle, Delaware

      Thank for reading my Hub. Some can be too stringent and inflexible which over time becomes redundant red tape. Regulations need to be more dynamic but I share your fear that completely vanquishing so many regulations and agencies is more than a bit extreme.

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      Howard Schneider 5 months ago from Parsippany, New Jersey

      Very interesting analysis, Angelo. The 2008 financial meltdown was caused by many factors including the ones you enumerated. I agree that our economy now under the Trump Administration will do well for the short term and even accelerate. Unfortunately this administration is stripping all the controls and regulations the Obama Administration put on it to prevent the excesses for causing another financial debacle. I fear we may see another in a few years. Great Hub.