The 2008 Financial Crisis- also known as the Great Recession- is a notorious event in US history largely caused by rampant deregulation in the financial industry. Kevin Canterbury of Arizona’s Redstone Capital Management notes that it is crucial that financial professionals recognize many of the key players in the crisis as this knowledge will help reduce the risk of future economic turmoil. Here, Kevin explores a few of the root causes of the financial crisis and how these pieces worked in tandem to cause on of the worst recessions in U.S. history.
Deregulation in the Industry
One of the primary reasons that the Great Recession could happen is a period of deregulation in the financial sector. For example, in 1999 the Financial Services Modernization Act repealed the Glass-Steagall Act of 1933. This let banks use deposits to invest. Later, the Commodity Futures Modernization Act further loosened regulations on derivatives. A big issue with this set foundation was that the banks had promised to protect their customers by only investing in low-securities, but that is not how the situation ended up playing out. Because watchdogs were paid by banks making transactions, there was an incentive to be less than transparent regarding the risks of certain investments. In addition to this, industry watchdogs could have stepped in to lessen the impact of some of these deregulation moves; however, many did not sound any alarms at this time.
Securitization and Predatory Lending Practices
The issues with the banks that contributed to the financial crisis were compounded through securitizations. Loans for mortgages provided by the bank could be sold on the secondary market, allowing the entities to make additional loans with the money received from the sale. Naturally, investors were the ones who took the risk of default because of this setup, but they were protected via credit default swaps. Seeing the financial incentive to seek out derivatives without fear of defaulting, soon everyone from individual investors, pension funds, and large banks had amassed them- but there was a problem. Since banks were incentivized to make money through derivatives, they wanted to have more mortgages as backing. This meant that many banks would offer loans for mortgages to people even if they were unlikely to be able to pay them back. The strategy would later come back to bite them.
Subprime Mortgage Crisis Followed by Interest Hike
At the turn of the millennium, the Federal Reserve cut interest rates, kicking off a period of rampant home financings. By 2003, the mortgage debt had increased from $460 billion in 200 to $2.8 trillion. Homeowners took advantage of the opportunity to pull equity to spend on their various needs and wants during this time, extracting $2 trillion in home equity from 2000 to 2007. This did not last and the and interest rates began do raise do to fears of inflation, and more problems began to occur in short order.
Home prices were peaking in 2006 while the market was slowing down, and the bubble eventually began to burst as prices spiraled downward. Interest rates were up 4% in 2006 versus 2004 and housing prices had fallen significantly, creating a situation where it was difficult for buyers to make their payments. After defaults on subprime mortgages began to increase, the real estate industry was imperiled- however, because funds had extended into so many other industries, the situation was the perfect storm for a stock market crash.