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Economic History: The Housing Crash of 2008



Background

The economic climate of the early 21st century was disastrous for American businesses and investors. The terrorist attacks on September 11th, 2001 and major scandals involving the accounting practices of corporations such as the Enron Scandal harmed the stock market heavily. Furthermore, the dot-com bubble burst occurred around the same time, causing further damage to the economy. In response to these incidents, the Federal Reserve’s target interest rate fell to 1% in the summer of 2003 from 6.5% in May 2000. Lower interest rates often benefit American companies and citizens in times of economic disaster. The lower mortgage rates allowed most Americans to buy homes without much trouble, spiking the prices in the housing market with the rise in demand. The subprime loans that emerged through this trend were sold to investment banks. These banks combined the loans together and sold them as financial instruments. This rapidly growing market of mortgage-backed securities and less strict capital requirements from the Securities and Exchange Commission (SEC) brewed a storm of very high risk-taking in banking. Banks were heavily relying on the high availability of homes and low interest rates through their investments.

The Crisis

As the economy strengthened, interest rates began to rise to their usual levels. While this would appear to be a sign of recovery and prosperity, it directly led to the housing market crash of 2008. The Federal Reserve boosted these rates after the rocky economic climate from the early 2000s began to fade away. Also, with so many Americans owning homes, investors’ reliance on home purchases would start to cause problems. Home prices declined sharply beginning in early 2006, leaving many with homes that were valued lower than what they paid for it. Lenders specializing in subprime loans went bankrupt from the lack of payments being made during this crisis. The effects of this economic disaster began to spread on an international level. The interbank market shut down over uncertainties about the development of the crisis. Central banks around the world sent out vast quantities of loans in an attempt to rescue international credit markets. Major banks unraveled, such as Northern Rock in Britain and Bear Sterns in the U.S.

The Recovery

In response to the housing crash, Congress passed a bailout package to buy assets such as mortgage-backed securities that were ruined by the crisis, invest in major banks, and send lifelines to mortgage companies like Fannie Mae and Freddie Mac. These investments would be recollected later on with interest, but they provided temporary relief and a way out of the recession. The package wasn’t put into action without some backlash, however. Americans accused the government of assisting the institutions that sparked the crash in the first place. Another new policy, the Dodd-Frank Wall Street Reform and Consumer Protection Act, restricted the practices of banks such as their control of their cash reserves. After millions lost their jobs and homes, the crisis finally dissolved.

What can we learn?

The 2008 crisis provides a multitude of valuable financial lessons to guide future generations and protect against a similar event as much as possible. While incidents like the housing bubble in this crisis are sometimes unavoidable, there are still precautions that can be made against them. First of all, the dangers of dropping interest rates to recover an economy and raising them again suddenly are made very evident through this crisis, as the low interest rates quickly saturated the housing market. Also, the practice of predatory lending, or intentionally taking advantage of subprime borrowers, backfired harshly in 2008. Besides being ethically questionable, the rise of the subprime lending market led to its hard fall in this disaster. Agencies in charge of releasing investment ratings have also learned to be more cautious, as the high ratings for the mortgage bundle market allowed for further investment despite the risk involved.

Vocabulary

  • Enron Scandal- the fall of the massive Enron Corporation, which provided energy, commodities, and services, after it was revealed that the corporation manipulated its financial records to make investment in the business seem more profitable

  • Dot-com bubble burst- many invested in websites during the dawn of the Internet out of speculation that the market would continue to improve, but dot-com companies did not perform as expected and financial decline ensued

  • Subprime loans- loans with higher interest rates offered to those who are more likely to not pay everything back

  • Financial instruments- legal agreements that hold monetary values

  • Mortgage-backed securities- mortgage loans that are collected in bundles by Wall Street banks and sold to investors

  • Securities and Exchange Commission (SEC)- government agency designed to protect against market manipulation

  • Interbank market- the trade between financial institutions of currencies and their derivatives

  • Central banks- banks that are allowed to manage a nation’s monetary policy; an example would be the Fed

  • International credit markets- markets involving the exchange of debt, including mortgage-backed securities

  • Assets- owned resources that can benefit an individual, corporation, or nation in the future

  • Fannie Mae and Freddie Mac- two mortgage institutions that are backed by the U.S. government to buy mortgages and sell them to investors

Sources

https://www.thebalance.com/what-caused-the-subprime-mortgage-crisis-3305696

https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp

https://www.thestreet.com/personal-finance/mortgages/subprime-mortgage-crisis-14704400


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