Global Financial Crisis in the US
Introduction
It was hard for the economists, professional analysts and policymakers among other players in the financial industry to foresee the crisis in the US mortgage lending industry in 2007 that resulted in the world's worst economic recession in two years' time (Sher and Iyanatul 2010). Initially, there was a housing bubble characterized by high house prices, low-interest rates, more support for subprime mortgage and increased speculation by the buyers (Acharya and Schnabl 2010). Eventually, there were decline of house market prices, increased lending rates and increased default and foreclosures by the mortgagors (John 2009). Notably, by mid-2008 the adverse effects of the crisis were felt in world’s stable economies like Japan and European countries (Sher and Iyanatul 2010).
In order to have a clear understanding of both the cause and impacts on the financial crisis, the essay will analyze the 2007-2009 global financial crises in the US economy and the measures taken by the US government to deal with the crisis. Particularly, the paper undertakes four key areas. In the first section, the study introduces the concept of the 2007-2009 global financial crisis in US and outlines the structure of the paper. In the second section, the study will give detailed discussion on the impact of the global financial crisis on the US economy. Finally, the essay will check measures taken by the US government to deal with the crisis in the third part and draw conclusions in the last part.
Impact of the 2007-2009 Global Financial Crisis on US Economy
Despite that the effects of the 2007-2009 global financial crises go beyond the US economy, the essay will confine its analysis on the US economy (Acharya, Cooley and Richardson 2010). The events and factors that led to the crisis associated with the world’s recession in several studies. Specifically, the housing bubble, resulting from constant rise in prices for houses in the US between the years 1999-2005 in comparison average wages (John 2009), contributed significantly to the world crises. It is also important to note that the prevailing low lending rates led to borrowing subprime mortgages. Consequently, induced demand for houses rose despite the high prices and speculation in the house industry. Generally, the speculations led to an increase in leveraged loans among financial institutions (Acharya et al. 2010). Eventually, house prices started dropping due to the constant wages. Notably, a slight increment in market prices of houses the U.S would have made them out of reach from most households. Given that lending late is negatively related to collateral value, increase in the increase depleted their values (Verick & Islam 2010). Expected, the default cases and foreclosures increased as the borrowers could no longer meet their monthly repayment. Therefore, such investment banks as the Bear Stearns and Lehman Brothers Investment Bank that had large mortgage stake were drastically affected investment banks to an extent of filing for bankruptcy (Adrian and Shin 2010). The unforeseen crisis has negative consequences in the U.S. economy ranging from high unemployment, low lending volumes, low-income expectation, loss of wealth and public mistrust (Tyler, David and Harvey 2013).
Increased Unemployment
The financial crises lowered the economic activities in the manufacturing, production and the construction industries in the US. Consequently, retrenchment and rate contracts termination to cut the losses increased. Moreover, most companies, halted hiring process and even closed some plants. Particularly, unemployment rates in the US rose to 4.9% (Sher and Iyanatul 2010). As such, to keep the employees the companies had to cut the working hours leading underemployment. However, it is important to note that workplace diversity have varied severity of the crises in terms of sex, age, skills and level of education as well as level of employment (Atkinson, Luttrell & Rosenblum 2013). For instance, cases of unemployment were more among young men, below the age of 25 years, in comparison to women in the same age bracket since majority of young men population worked in the manufacturing, construction and production. These sectors were hard hit by the crises. Besides, the unskilled or less skilled employees suffered the same fate; the sectors they worked in were significantly hit by the crises, and employers were reluctant to suck the skilled employees due to high hiring and turnover costs. Additionally, the temporary contracted employees that were not protected by labor laws were also susceptible to the effects of the crises in comparison to those employed on permanent basis. Figure.1 below illustrates the impact of unemployment as a result of the 2007/2009 financial crisis between the years 2007 to 2010.
Figure 1
Figure 1: Layoffs and hires in the US during the crisis, Monthly Data (Dec 2007-Jan 2010)
Source: Sher and Iyanatul (2010)
Reduced Wealth
The net worth of families' accumulated savings dropped by approximately 24% during this period, years 2007-2009. The drop may was partly associated to the decline in the value of durable assets like houses. Additionally, the high-interest rates that resulted from the crisis could be the cause of the drop in wealth (Shiller 2012). Presumably, high interest rates lower affordability and accessibility by the households. Particularly, joblessness led to depletion of wealth due to loss of value and low liquidity of the depreciated assets leading to low disposable income (Barajas et al. 2010). However, owing to the autonomy of decisions and choices regarding consumption, saving and investment, the severity of wealth loss varied to a great extent (Ben-David, Franzoni and Moussawi 2012). Specifically, the rate of saving at the time was insignificant. Consequently, the level of investment was also low since savings and investments have a positive correlation, other variables equal. Still, the interest on the savings was too low to attract sizable savings from the fortunate households. Eventually, the aggregate consumption on nondurable goods and services dropped persistently (Tyler, David and Harvey 2013). Figure.2 illustrates consumption information on the loss of wealth.
Figure 2: Fall in Consumption May Capture Large Downward Revision to Future Income Expectation.
Source: Tyler, David and Harvey 2011
Low-Income Expectation
The financial crisis had negative effect on the expected income, particularly, loss of jobs lowered the households' probability to buy or own houses among most of the households. As such, house ownership eventually declined as a result only to pick in 2011. According to credible reports, many young people working still lived in their parents' homes due to uncertainty of financial outlook, which countered investment opportunities in the US economy (Tyler, David and Harvey 2013). The low investment and saving rate shattered the hopes of households in regard to better incomes in the future; specifically, they expected lower incomes owing to the poor economic performance. Consequently, they sold their mortgages which in turn affected their spending and saving decisions (Bordo and Landon-Lane 2010). Here, the households lowered their appetite on durable assets thus lowering US GDP. Moreover, due to increases risks costs most households became risk averse in risky investments and showed preference for government securities or overseas investments. Ultimately, the economic activities dropped due to low GDP and minimal returns from low earnings from the government bonds.
Figure 3: 2007/2009 Crisis Drastically Lowered Income Expectations
Source: Tyler, David and Harvey (2013).
Lost Public Trust
Additionally, the 2007/2009 crisis put economic system adopted by the US government to a test. Particularly, the severity of the crises brought doubts on the ability of government institutions and the monetary policies in place to absorb business cycles (Tyler, David and Harvey 2013). Particularly, the government move to lend through commercial banks to high-risk customers through subprime mortgages, with the intention of making houses affordable to low-income earners in the US and the legislation that allowed for foreclosures attracted wide criticism (Borio and Disyatat 2011). More so, their selective lending denied some investment banks like Bear Stearns. However, the government was quick to offer emergency loans to such banks to save them from going under (William 2009). Generally, the public viewed the government move as an economic offense since the investment bank was reckless in the fast place. Similarly, the financial institutions were so eager to make huge profits and grow their market without giving much consideration to the risk analysis, lending standards and documentation process (Cheung, Fung and Tsai 2010). The aggressive lending is indicative of in discipline for financial institutions. Moreover, the monetary policymakers sustained low lending rates for too long leading to over borrowing and excess money in the circulation. Clearly, the reckless mistakes committed by the key stakeholders in the financial industry eroded the public trust.
Reduced Lending
There several features indicative of the housing bubble such as low lending rates in the markets which prevailed for a long time than the norm. It is clear that the lenders miscalculated the risks involved in mortgage-backed securities initially (Chudik and Fratzscher 2011). As a result of this generous lending by the financial institutions, there was so much money in the market, and this triggered inflation. The adopted correction measure by the Federal Reserve raised the interest rates resulting in high default rates on mortgages (Duca, Muellbauer and Murphy 2010). This reduced lending between banks and other financial institutions and accessibility of short-term loans became impossible while trade-ins were frozen. Consequently, banks started hoarding cash making accessibility of loans by personal difficult (Sher and Iyanatul 2010). Principally, low money supply leads to high-interest rate; hence this contributed to the changed o financial institutions’ perception on risks, particularly, the avoided borrowers who assumed risky ventures for fear of loss and defaulting as were the case during the crisis (Frankel and Saravelos 2012).
Measures taken by the US Government to Combat the 2007-2009 Global Financial Crisis
The situation demanded immediate government intervention to avoid ripple effects in the economy such as depression. Therefore, such measures as new fiscal policies, new legislations formulation, reviewed labor policies, liquidity provision policies and capital injection into financial institutions as well as intervention by other regulatory bodies came into force. The discussion below highlights the some of the measures taken.
Fiscal Policies
The Federal Reserve Board strategized to combat the crisis in four ways. Firstly, it reduced the interest rates to 2% in August 2008 (John 2009). Similarly, it closed the gap between the funds rate and the discount rate from 100bp to 25bpn to provide financial institutions with enough cash to lend its customers. Still, it adopted short-term financing to the financial institutions through a plan known as Term Auction Facility (TAF). Using this plan, financial institutions could bid for and receive funding of up to $50 billion without disclosing their identity against securities that lasted for 28-35 days (Reinhart and Rogoff 2010). This plan was successful as a number of commercial banks got access to short-term funding much easier than before, even though the plan was short-lived and viewed as a short-term measure to combat the financial crisis (John 2009). The Federal Reserve further ensured that banks had enough varieties of assets to use as collateral when acquiring loans (Fratzscher, 2012). It also offered to take up the contingent liabilities incurred by the banks. The aim of these initiatives, though some were short-lived, was to make banks more liquid to correct the credit crunch that had been caused by the crisis, which would return the risk (Helleiner 2011). Finally, the Fed also intervened in the take-over of Bear Stearns just to make sure that it did not collapse completely.
New Legislation
In February 2008, an Economic Stimulus Act was passed which aimed at attracting wide investments through provision of tax rebates to low-income households. This move improved the features of mortgages that could be purchased by Fannie and Freddie (John 2009). The third provision of the Act was specifically tailored to counter the condition that Fannie and Freddie Home Loan Mortgage Corporation had put in place during the crisis, complete avoidance of high risky mortgages (Jordà, Schularick and Taylor 2011). Had the complete avoidance of risky mortgage prevailed, most low-income households could not afford mortgages. On the other hand, the investors would be attracted to tax plans like tax holidays, tax exemptions as well as easy and cheap access to loans (Poole 2009). Additionally, a second legislation, Housing and Economic Recovery, passed with the aim of addressing the housing crisis (Kenc and Dibooglu 2010). Specifically, the Federal Reserve offered a 10% tax refund on first-time mortgage buyers through this legislation. Furthermore, it injected lots of cash into Fannie and Freddie Home Loan Mortgage Corporation to cater for capital finances as well as stabilize their liquidity (Reinhart and Rogoff 2013).
New Labor Policies
The crisis left so many households in the US without jobs, which necessitated measures that would address the issue of unemployment at the time and in the future. Policymakers needed make drive changes on the labor market adjustments, inducing demand and offering credit crunch (Laeven and Valencia 2010). The adopted policies aimed at maintaining and increasing labor demand and provision of income support by targeting the groups that were hit most by the financial crisis (Sher and Iyanatul 2010). Particularly, the support took the form of training the unskilled and semi-skilled training as well as expanding employment services to reduce employees’ vulnerability in cases of mass layoffs.
Reduced Interest Rates and Capital Injection Policies
The basic move by the Federal Reserve was to provide liquidity to financial institutions and banks. it attained this goal by cutting down on interest rates and increasing loan accessibility for the borrowers in banks and other financial institution. Consequently, it would stimulate demand and investment in the economy. Moreover, the move protects mortgage lenders from the risks of foreclosures and mortgage delinquencies (Marshall 2009). Afterwards, the Federal Reserve came up with a plan, Troubled Asset Relief Program (TARP), which focused on purchasing Stocks from the financial institution to give them with capital. Here, it injected over $200 billion to provide capital to financial institutions (Adolfo, Ralph, Thomas and Dalia 2010). The success of this policy was wide-spread since it targeted the large banks in the economy that were on the verge of collapsing due to the financial crisis (Obstfeld 2012). Additionally, the US Treasury supplemented the plan by instituting a Temporary Guarantee Program in 2009 and later allocated it $50 billion as security for investments in money markets (John 2009).
Intervention by other Regulatory Bodies
The most common bodies among the other regulatory community are the Federal Deposit Insurance Corporation and the Office of Thrift Supervision. Conjointly, the bodies took the initiative to supervise the disposal of assets and liabilities of IndyMac mortgage lending bank, into federal conservatorship. Moreover, it increased its deposit insurance for member banks (Milesi-Ferretti and Tille 2011). Additionally, SEC, a security regulator, facilitated restriction of short-selling with the aim of protecting the value of securities of the financial institutions. Moreover, SEC was instrumental in improving the investors’ confidence of in the securities (John 2009). Still, there was adoption of several policies on credit rating agencies to avoid conflict of interest (Nier and Merrouche 2010). Finally, SEC had a mandate of ensuring adherence to responsibility in regulating Credit Default Swaps to tone down the effects of the crisis.
Conclusion
It is clear from this paper that stakeholder in the US economy financial industry had not foreseen the occurrence and effects of the great recession that took place in 2007-2009. The housing bubble graduated to recessions that destabilized the US economy. It is also clear that high demand of assets lead to rise in prices of such assets at a higher rate than the average wages. Particularly, if the states occurrences happen at low-interest rates sustained over a long period it could adversely affect the economy. This was the case in the US economy where house prices were constantly raised, and interest rates remained as low as 1% while average wage had remained constant over the time. This led to high demand for the houses despite that the prices were high.
The study also shows that the stakeholders’ actions have a bearing on the effects of financial crises, particularly those blamed for making the wrong decisions. Thus, the financial institutions recklessness in risk assessment and were too generous in lending irrespective of the creditworthiness of the borrowers required the institutions fueled the crises. Hence, after assessing the risks, especially for subprime mortgages, interest rates had to go up leading to drastic drop of house prices. Consequently, the mortgage owners were eager to dispose of the assets because of the risk involved. Still, financial crises lead to decreased wealth and opportunities in the economy. This lowers the demand and investment warranting measures to save the economy from deflation. For instance, the Federal Reserve had to come up with liquidity and capital injection policies to salvage the situation. The study is also indicative of importance of labor laws in address the alarming rates of unemployment during crises. However, a report on effectiveness of policies and measures adopted to stabilize in the US economy would aid in making future decisions in the labor and credit markets. As such, future studies should look at that area.
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