Running head: CAUSES OF THE 2008 FINANCIAL CRISIS 1

Causes of the 2008 Financial Crisis

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CAUSES OF THE 2008 FINANCIAL CRISIS 2

Causes of the 2008 Financial Crisis

America's financial system almost collapsed in 2008. Some banks failed, but the U.S

government supported key ones. Consequently, the financial crisis resulted in poverty and

unemployment. Unsuitable deregulation, weak supervision, excess risk and leverage, growing

inequality, and rating agencies caused the 2008 financial crisis. This paper describes rating

agencies and deregulation.

The role of credit rating institutions was pivotal in the financial crisis. These three

agencies included Moody's, Standard & Poor and Fitch. They played a crucial role in

securitization (Daumal, 2018). These agencies were brokers between banks that securitized

mortgage and investors. Investors trusted these agencies to retrieve precise information on

securities. Between 2002 and 2007, the rating agencies highly rated most financial institutions.

The incorrect rating convinced most investors that toxic subprime tranches ratings matched the

U.S Government bonds (Daumal, 2018). It further inspired the demand for mortgage loans

causing the housing bubble. However, the decline of housing prices in 2007 increased the

default rates and caused investment loss. These rating agencies misled investors about the quality

of mortgages. They rated toxic loans as safe ones (Daumal, 2018). They also failed to examine

the quality of personal mortgages within mortgage-backed security. Moreover, agencies

underrated the high connection between the defaults of mortgage loans. The assumption on

continuous housing prices misguided banks to invest in the sector. However, most borrowers quit

their homes during the housing bubble. The houses’ value was lower than the amount borrowed,

leading to a significant loss.

The International Monetary Finance claimed that flawed incentives and conflicts of

interests caused the agencies’ negligence. Mortgage firms paid agencies well, leading to the
CAUSES OF THE 2008 FINANCIAL CRISIS 3

manipulation of ratings to please customers (UNCTDA, 2010). Moreover, investors negotiated

ratings, and only compensated agencies for rated deals. Therefore, the risk of losing business

caused biased ratings and models. Competing agencies offered suitable grades to remain relevant

in the industry. They lacked procedures and policies to manage the rating procedure and never

disclosed vital information to investors. Investors and regulators also missed the conflict of

interest in credit rating services leading to the loss of housing investments.

Deregulation of the financial sector in the early 1990s also caused the financial crisis in

2008. The Financial Service Modernization Act repealed the Glass-Steagall Act of 1933. The

revocation allowed banks to invest in derivatives using deposits (UNCTDA, 2010). Bank

lobbyists needed the change to compete with international organizations. They vowed to invest

in low-risk securities to safeguard the clients. However, banks invested in risky mortgage

securities. The Act further deregulated default swaps and other derivatives (Daumal, 2018).

Deregulation allowed financial institutions to take extraordinary risks. They were optimistic

about increased asset prices and economic fortunes (UNCTDA, 2010). They also participated in

sophisticated financial engineering that exaggerated and concealed risk. Unfortunately,

supervisors and regulators remained inattentive to bank operations. They upheld the culture of

deregulation and believed that financial markets could effectively regulate themselves. Thus, the

regulatory oversight failed and exposed the system to excess risk-taking.

The Federal Reserve’s failure to control toxic mortgages and the unjustifiable rise in

house prices polluted the financial system. Besides, the economy experienced a decrease in

lending standards and increased risky lending between 2001 and 2007(Daumal, 2018). The

number of risky loans increased in the same period leading to securitization. People had the

pressure to build many homes. The regulators also failed to examine borrowers’ ability to
CAUSES OF THE 2008 FINANCIAL CRISIS 4

service their debt. The Financial Crisis Inquiry Commission noted that borrowers defaulted in 42

percent of the loans (Daumal, 2018). Lenders and brokers never helped borrowers in managing

risk. They broke the principle of sound banking practices. Approximately 38 percent of

borrowers with adjustable-rate mortgages never understood their interest rates variances. Thus,

the threat of borrowers’ failure to repay loans increased. Brokers and originators further lacked

incentives to screen the risk of increased lending. Besides, minimum underwriting and consumer

safeguard standards never applied to financial firms that originated loans. Eventually, the total

mortgage debt rose from 5.3 trillion dollars in 2001 to 10.5 trillion dollars in 2007. The mortgage

debt for each household also increased from 91,500 dollars in 2001 to 149,500 dollars in 2006.

The national average home prices also moved 152 percent between 1997 and 2006, attaining the

highest record of 227,000 dollars in 2006 (Daumal, 2018). Americans struggled to pay inflated

prices for their houses. However, they stopped servicing their loans in 2006. The mortgage

interest rates skyrocketed while home prices reduced. Subsequently, banks and investors with

toxic loans lost their investments and massive cash. These significant losses caused the financial

crisis.

Overall, the deregulation of the financial sector caused the 200 financial crisis. It

permitted speculation in derivatives backed by cheap mortgages. High property values and easy

mortgages convinced many people to seek home loans. This move caused the housing market

bubble. However, when the Federal Bank elevated interest rates, the resulting high mortgage

payments curtailed borrower's ability to repay. Therefore, the housing market collapsed.

Similarly, the crash in the housing sector affected the U.S financial industry. This is because

home loans were linked to derivatives, hedge funds, and credit default swaps. Hence, America's

banking industry affected the global financial systems leading to the 2008 financial crisis.
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References

Daumal. M. (2018). The Economic and Political Causes of the 2008 U.S. Financial Crisis.

Retrieved from http://pseweb.eu/ydepot/seance/513077_PapierDaumalCrise.pdf

UNCTDA. (2010). The Financial and economic crisis of 2008-2009 and developing countries.

Retrieved from https://unctad.org/en/Docs/gdsmdp20101_en.pdf