What Was the Main Cause of the Financial Crisis in 2007-2009?
The intention of this essay is to provide an in depth and critical analysis of the financial crisis that took place between 2007-2009, in particular focusing on some key issues raised by the Foote, Gerardi and Willen paper ‘Why did so many people make so many Ex Post bad decisions?’ Whilst there were many contributing factors, it is clear that a specific few played a particularly dominant role, primarily the ‘Bubble Theory’, irresponsible regulation, toxic CDO’s and $62 trillion of CDS’s.
‘That’s what bubbles are: they’re examples of mass delusions’ (Norcera, 2011). Bubble theory’s are by no means a new school of thought, in fact they date back to the Dutch Tulip bubble in the 1630’s and it is these types of bubble that are believed, by many economists, to be the primary cause of the foreclosure crisis. The bubble theory explains the crisis as a natural progression of overly optimistic price expectations for a particular asset class, recently the US housing market. When the housing bubble began to enlarge, lenders were lulled into a false sense of security, which lead to large amounts of credit being extended to ‘sub prime’ borrowers, people who had shady or uncertified credit history. However due to the inflating house prices the banks seemed to have little concern towards the credit being repaid. Although this credit was issued to subprime borrowers through the securitised credit market, securitisation was not necessarily the definitive cause of the crisis, but what it did was act as a catalyst allowing borrowers and investors to undertake their desired transactions. With this appetite for risk from lenders and interest rates being cut to 1% by the Fed, institutional investors were eager to chase higher returns. The opportunity encouraged investment banks to anti up their leverage and create a higher yielding product which was directly linked to an ‘ever rising housing market’.
The emergence of Special Purpose Vehicles (SPV’s) allowed banks to over
‘That’s what bubbles are: they’re examples of mass delusions’ (Norcera, 2011). Bubble theory’s are by no means a new school of thought, in fact they date back to the Dutch Tulip bubble in the 1630’s and it is these types of bubble that are believed, by many economists, to be the primary cause of the foreclosure crisis. The bubble theory explains the crisis as a natural progression of overly optimistic price expectations for a particular asset class, recently the US housing market. When the housing bubble began to enlarge, lenders were lulled into a false sense of security, which lead to large amounts of credit being extended to ‘sub prime’ borrowers, people who had shady or uncertified credit history. However due to the inflating house prices the banks seemed to have little concern towards the credit being repaid. Although this credit was issued to subprime borrowers through the securitised credit market, securitisation was not necessarily the definitive cause of the crisis, but what it did was act as a catalyst allowing borrowers and investors to undertake their desired transactions. With this appetite for risk from lenders and interest rates being cut to 1% by the Fed, institutional investors were eager to chase higher returns. The opportunity encouraged investment banks to anti up their leverage and create a higher yielding product which was directly linked to an ‘ever rising housing market’.
The emergence of Special Purpose Vehicles (SPV’s) allowed banks to over
References: Nocera, Joe. 2011. “Inquiry is Missing Bottom Line.” New York Times, page B1. January 29 Journal of Economic Perspectives—Volume 24, Number 1—Winter 2010—Pages 73–92 Cordell, Larry, Yilin Huang, and Meredith Williams. 2011. “Collateral Damage: Siz- ing and Assessing the Subprime CDO Crisis.” Federal Reserve Bank of Philadelphia Working Paper Money morning Financial Crisis Inquiry Commission. 2010. “Credit Ratings And the Financial Crisis.” Pre- liminary Staff Report, June 2, 2010 The Credit Rating Agencies and TheirContribution to the Financial Crisis Brunnermeier, Markus K. 2008. “Bubbles.” In The New Palgrave Dictionary of Eco- nomics, eds. Steven N. Durlauf and Lawrence E. Blume, second edition Foote, Christopher L., Kristopher Gerardi, and Paul S