The 2007 Financial Crisis, Its Ultimate and Proximate Causes, Consequences, and Prevention

The 2007 Financial Crisis, its ultimate and proximate causes, consequences, and prevention

Philip Davis

Abstract

This paper looks at the United States financial crisis of 2007 and its causes, consequences, and prevention. Findings from several different scholarly articles and journals were analyzed and tested using data from FRED. The data does indeed back up most of the causes and theories presented in the various journals and articles studied.

Introduction

What were the main causes of the housing bubble of 2007 and what were/are the consequences? This is an important issue to be studied because of the large effect it had on not only the United States economy, but the world economy. This economic depression took several years to recover from. The causes must be correctly identified and avoided to prevent future collapses from happening. There were many causes that will be explored including a breakdown of ultimate and proximate causes. Some of the consequences of the housing bubble will also be explained. The severity of the recession could’ve been prevented. That is why we must take the time and effort to study it and correctly identify its causes.

There were many causes some ultimate and some proximate and it is important to figure out how those causes interacted with each other and possibly caused each other creating a domino effect. Not only is it important to be able to interpret other’s work and use that as a starting point, but it is also important to be able to gather the data, analyze it, and make conclusions based on the findings. Analyzing data to determine leading and laggings variables could be the key to figuring out some of the causes of the recession. Hopefully these studies and findings can be used to prevent history from repeating itself.

Literature Review

        From 1997 to 2006, United States nominal housing prices had risen 188%. A mere three years later, the prices had plummeted 33% (Levitin & Wachter, 2012). The global market reacted almost immediately and economic activity on all levels of economies decreased. In 2008, the already poorly performing market fell even more, following the collapse of Lehman Brothers and several big government bailouts. These events resulted in a big increase in counterparty risk when banks face large write-downs. The solvency of established banks was questioned and contributed to this. This acceleration resulted in a higher demand for quality. That resulted in decreased yields on government securities and wholesale funding fell, which led to a messy deleveraging process that rapidly spread across the rest of the world (Wagner, 2010). Even the private equity markets were hit hard.

Subprime lending was a huge part of the crash. Subprime lending is the practice of issuing mortgages to people who have lower than normal credit ratings. There inherently carry more risk for the issuer. Stone (2009) has four fundamental causes of the collapse. They are a wide and widening income inequality, a persistent and pervasive racism in housing provision, treating housing increasingly as a speculative commodity at all levels, and an over dependence on debt and the private capital markets to finance housing. The increasing income inequality resulted in more people who were not able to meet a substantial down payment, forcing them to take a subprime mortgage and more and more of them were being issued every day.

Pajarskas and Jociene (2014) state that the proximate cause of the financial crisis was the sudden decrease in house prices. This alone wasn’t the cause though. The combination of the sudden decrease and the large number of subprime mortgages issued at the time led to heavy losses on mortgages and mortgage related instruments. The authors also argue that one of the ultimate causes was the dot-com bubble collapse and the 9/11 turmoil. The Federal Reserve reacted to both events by lowering interest rates to soften the blow. These low interest rates incentivized the lending of subprime mortgages and made mortgage payments cheaper, increased the demand for homes, and encouraged investment into the United States mortgage market. A lot of this was also because banks and financial institutions should not have been lending these mortgages in the first place. They knew that the borrowers wouldn’t be able to repay the loan but lent it to them anyway. The borrowers banked on the continued appreciation of home values and the ability to refinance in the future.

        Huston and Spencer (2016) believe that the Fed utilized several unusual policy tools during and after the financial crisis. They listed them as bailouts of selected financial institutions, rescue of the commercial paper market, the manipulation of interest paid on bank reserves, and the announcement of a plan to keep the policy rate low far into the future (Huston & Spencer, 2016). They also mentioned the Fed’s policy to keep long-term interest rates low called Operation Twist, quantitative easing round one (QEI-QEIII) and the purchase of bonds in mortgage-backed security markets. The Fed first got involved in Q3 of 2007 when they cut the discount rate which extended the loan repayment period and initiated the Term Auction Facility. The Fed Chairman at the time, Bernanke, said that these aggressive policies should work to lower the interest rates and enhance wealth creation. This was an expansionary monetary policy. At the time, the fed funds rate was fixed nearly at zero which facilitated the lower long-term interest rates that they were instigating through the purchase of long-term securities. The authors wanted to see whether aggregate monetary policy variables like the monetary base or excess reserves had any influence on the equity and housing markets during the financial crisis and if so, how much of an effect was it. They also wanted to see the effect of the purchases of mortgage-backed securities and Operation Twist on the market.

        Overall, Pajarksas and Jociene (2014) provide a plausible cause and have more than enough proper explanation to back it up. Some of the issues Stone (2009) seem to be more opinion based and hard to quantify but are still semi-plausible options. Levitin and Wachter (2012) and Wagner (2010) take a look at the picture from afar and have more generalized theories but also picked some interesting areas like private equity markets and more global effects.

Analysis and Results

The investment-savings, liquidity-money model or IS-LM for short, is a Keynesian model that shows how the market for economic goods (IS) interacts with the loanable funds market (LM).  The following is the IS-LM curve: