The two thousand and eight financial crises resulted in significant economic turndowns. Before it began in two thousand and seven, prices of housing rose, new investment options emerged, and risk diversification increased. Following the crisis, house prices fell by huge percentages. It exposed economic weaknesses of the United States. Additionally, it led to an increase in the unemployment rate by ten percent (Mishkin, 2011). Approximately, nineteen trillion dollars of household wealth were lost. Lehman Brothers collapsed in two thousand and eight affecting the global financial system. Taxpayers had to bail out various banks to stabilize the system. This paper examines the effect of 2008 financial crisis on American banks.
Before the crisis, irresponsible mortgage lending was witnessed in America. People with a poor history of credits got loans. They struggled to pay them leading to a crisis. Mortgages were then passed to financial engineers. These were placed into ‘low-risk securities’ by pooling them together (Mishkin, 2011). They were used in backing collateralized debt obligations (CDO). Investors rushed for the securitized products since they appeared relatively safer. Rapid changing of America's housing market (AHM) exposed various fragilities in the financial system. The mortgages slumped in value and CDOs became worthless. Banks lost trust in each other, as well as the system. This mistrust enormously affected the banking system.
Additionally, securitization played a significant role in affecting banking stability. It transformed the sector leading to loans depersonalization. This enables banks to increase investment complexity and credit bank transfers. Its main aim was to enhance mortgage liquidity, as well as risk reduction (Ramskogler, 2014). Besides, securitization extended housing financed through mortgages. It allowed for mortgages’ selling and writing off. It aimed at spreading of risks to avoid various financial problems. However, it resulted in the production of bad mortgages, which were quickly passed to other individuals.
Complexities created by securitization were a primary contributor to the financial crisis. This is due to the underestimation of risks involving securities backed by mortgages. This led to increased circulation of money in the United States housing market. Moreover, it caused continuous house prices appreciation. Banks lowered their interests to attract more individuals. The combination securitization and irresponsible lending are considered major causes of financial crisis. They also had a significant role in the collapse of various United States banking institutions.
The financial crisis led to losses of money by banks in America. This was due to the freezing of interbank lending, mortgage defaults, and drying up of credits. Moreover, it led to the formulation of various regulations that affected banking systems. In response to financial crisis, Obama administration introduced massive reforms (Farrar & Mayes, 2013). These reforms were channeled through ‘Dodd-Frank Wall Street Reforms and Consumer Protection Act (DWRCPA).’ Provisions of the act aimed at reducing various risks in the banking sector. Additionally, it protects consumers from irresponsible borrowing and abusive mortgage practices by financial institutions.
The lack of mutual trust led to frozen interbank borrowing. Banks could hoard cash and lend to creditworthy financial institutions. This resulted in reduced flow of money and accessibility. Interbank markets have been blamed for the financial crisis. Besides, the mistrust led to increased cost of borrowing. This also raised interest rates banks applied on loans to counterparties. Lending difficulty resulted in the breakdown of financial systems. It also reduced the ability of people to get loans. Lack of trust led to reduced circulation of money in the system.
Monetary policies responding to the crisis resulted in increased Federal Reserve Bank balance sheets. It built up reserves that were made available to banking systems. Federal Reserve Bank provided liquidity to various shaky systems of finance. Additionally, it pursued policies for qualitative easing (QE). This enabled the bank to purchase certain assets from struggling private sectors. Assets were pumped into the struggling United State economy. The Federal Reserve Bank offered loans to various banks, as well as traditional counterparties (Farrar & Mayes, 2013). Loans provided liquidity to banks, as well as financial intermediaries. This resulted in increased reserves from thirteen to eight hundred and fifty billion dollars.
The increased reserves were essential in allowing banks to hold liquid assets following a crisis. The main aim was to protect them from financial shocks. Additionally, QE policies conducted by the Fed aimed at improving the financial situation (Dudley, 2016). These policies also led to a change in its asset composition. The Fed offered loans to banks, as well as non-banks. This increased the range of collaterals. Moreover, the purchasing or retention of property from borrowers significantly improved reserves. The Fed purchased various mortgage-based, which reflected on its balance sheets.
The crisis also resulted in collapsing of different financial institutions including banks. This massive failure was occasioned by slow action to curb the financial crisis. Bank failures also resulted from increased engagement in real estate businesses, as well as funding strains (Ramskogler, 2014). Banks increased their exposure to various real estate risks towards the crisis. However, it was not uniformly conducted across real estate businesses. This was a recipe for failure of the financial system. The failure of borrowers to pay back their loans plunged banks into financial crisis.
The Fed worked on improving banks' stability during and after the crisis. It reduced specific systemic risks by improving security, as well as payment of settlement systems. Additionally, it provided incentives for various derivative transactions (Ramskogler, 2014). The Fed also designed mechanisms for dealing with massive failures of important institutions. Its primary objective was to contain the crisis. This is done by offering liquidity support. The bank acts as a last resort lender. Besides, tools such as monetary policy rate (MPR) and collateral flexibility may be utilized. The Fed made a commitment to keep the rate lower for longer periods. This assisted in the recovery of various financial institutions.
The Federal Reserve Bank employed flexible monetary policy to counter the financial crisis. It aimed at keeping liquidity flush for supporting the economy from economic impacts. However, this was done with cushions. Excessive flexibility could have led to downward pressure on the dollar. Cooperation of the Fed and other fiscal agencies was crucial. It allowed for support during the crisis. This resulted in the growth of credits and monetary aggregates. Additionally, the Federal Reserve Act (FRA) allowed for an extension of credits to corporations, partnerships, and individuals (Dudley, 2016).
In conclusion, the 2007-2008 financial crises were caused by various factors such as irresponsible lending and securitization of mortgages. It affected the United States economy leading to loss of jobs. Financial institutions' stability was also affected. Besides, various high profile banks collapsed during the crisis (Mishkin, 2011). This led to downward pressure on the dollar. The Federal Reserve Bank instituted various mechanisms aimed at restoring collapsed financial institutions. Additionally, the Dodd-Frank Wall Street Reforms and Consumer Protection Act (DWRCPA) also played a significant role in restoring the United States financial system.
References
Dudley, W. C. (2016, March 31). The Role of the Federal Reserve—Lessons from Financial Crises. Retrieved from Federal Reserve Bank of New York: https://www.newyorkfed.org/newsevents/speeches/2016/dud160331.
Farrar, J. H., & Mayes, D. G. (2013). Globalisation, the Global Financial Crisis and the State. Cheltenham, MA: Edward Elgar Publishing.
Mishkin, F. S. (2011). Over the Cliff: From the Subprime to the Global Financial Crisis. Journal of Economic Perspectives, 49-70.
Ramskogler, P. (2014). Tracing the origins of the financial crisis. OECD Journal: Financial Market Trends, 47-61.
