Global Financial Crisis of 2007-2010 Research Paper Starter

Global Financial Crisis of 2007-2010

(Research Starters)

Because of the numerous causes of this event, the U.S. recession and subsequent global financial crisis that began in 2007 has generated a great deal of academic and political interest in understanding its nature and how its repetition may be avoided in the future. This paper will cast a light on the roots of the 2007-2010 global financial crisis, its impacts and the tools employed to bring it to a close.

Keywords: Community Reinvestment Act (CRA); Federal Reserve Bank (Fed); Global Economics; Housing Bubble; Recession; Subprime Mortgage; Troubled Asset Relief Program (TARP)


Adherents to the familiar George Santayana axiom, "Those who ignore history are condemned to repeat it," would find validation in the history of recessions in the United States. One of the worst recessions in U.S. history took place when a land speculation bubble (an uncorrelated increase in prices) began to rapidly collapse upon itself. Banks, fearful of insolvency, suspended certain transactions, sending the economy into a severe recession that lasted for a year. This recession was at the time the worst recession the United States had ever experienced. More importantly, it was one of the first recessions in U.S. history, commencing in 1797, less than 10 years after the Constitution was ratified.

The "Panic of 1797," as it was known, would be succeeded by dozens of recessions over the course of the following two centuries. This list includes what most historians deem the worst recession in U.S. history: the Great Depression of the 1930's. The first decade of the 21st century began with a severe recession, exacerbated by the horrific terrorist attacks on the World Trade Center and the Pentagon in 2001. Only a few years after that recession came to an end and the economy grew again, another recession began. This period, which began in 2007, resembled the Panic of 1797 in many ways, although its severity and global impact most commonly drew comparisons to the Great Depression.

There are those who believe that the global recession of 2007-2008 and the subsequent two-year crisis it created came unexpectedly, while others claim to have seen the warning signs more than a year before it began. Because of the numerous causes of this event, the recession of global financial crisis that began in 2007 has generated a great deal of academic and political interest in understanding its nature and how its repetition may be avoided in the future. This paper will cast a light on the roots of the 2007-2010 global financial crisis, its impacts and the tools employed to bring it to a close.

The Housing Bubble

Similar to the Panic of 1797, the roots of the global financial crisis of 2007-2010 can be found in real estate. After the United States began reemerging from the 2001-2004 recession, housing prices began to show unusual upward mobility. Political leaders and other observers, however, were clouded by the apparent good news surrounding home ownership — more homes purchased meant more jobs and more consumer spending. Then again, the rise in housing prices could not be correlated to any other area of growth. In fact, many economists argued that what was occurring was not a sign of economic growth but a housing bubble (an unexpected and temporary inflation in housing prices) that was doomed to burst and contract. In 2005, that possibility became reality, as a number of key markets saw housing prices decline. Then-Chairman of the Federal Reserve Bank (the Fed) Alan Greenspan acknowledged that the market, in some areas, was becoming "frothy," but said that a housing bubble was unlikely (Freeman, 2005).

By 2006, Chairman Greenspan's comments were largely discredited. In fact, many began to turn on the Fed, suggesting that that institution's recommendation that interest rates stay at record low levels (a policy that began in the late 1990s) started a housing boom. Home purchases were promoted by the government as contributors to individual wealth and retirement plans. The Fed even made mortgage interest rates tax-deductible, another incentive for homeowners to buy homes and make renovations thereto (Kohn & Bryant, 2010). Home ownership increased with the government's message to Americans that the more real estate they owned, the greater their wealth would be.

The Community Reinvestment Act

The increased number of home purchases that occurred was also attributable to another trend. Lending institutions had begun to sell subprime mortgages to a growing number of homeowners. Subprime mortgages are housing loans that are offered to people with low incomes and/or poor credit. Subprime mortgages have been in existence since the 1990s, although the government strongly encouraged banks to provide affordable loans to low-income and debt-ridden residents since the 1970s, when the government passed the Community Reinvestment Act (CRA) to prevent discrimination among mortgage programs (Brook, 2008). The CRA gave rise to the government's push for lending institutions to have available mortgages that the poor could afford. Subprime lending was ardently backed by the government, including the mortgage security giants Fannie Mae and Freddie Mac. Still, in light of the fact that subprime lending involves providing individual loans of hundreds of thousands of dollars to people already saddled with debt and/or poor credit, there is an obvious risk attached to the practice. Still, the government, Fannie Mae and Freddie Mac forged ahead with the pro-subprime lending campaign (Brook, 2008).

Because the government was actively promoting subprime lending (and apparently looking the other way on predatory lending), lending institutions became focused on securing high volumes of such mortgages. Major financial institutions, like AIG and Merrill Lynch, worked diligently to compete for this business by acquiring smaller lenders with reputations for subprime lending (Dickey, 2010). These lenders were paid not based on the quality of the mortgages but by volume, and major institutions took account of this volume and the profits it yielded. Indeed, subprime lending presented great potential returns in the short term.

By 2007, it became clear that the risks associated with subprime mortgages were very real. A stagnant economy meant more people were making less and starting to realize that they were unable to meet their financial commitments. The Fed, which is supposed to protect banks through regulation, went instead with the tide, supporting the subprime industry and the dangers they represented. In fact, the Fed did not require financial institutions to set aside the adequate amount of money to offset potential losses — this regulatory requirement was woefully outdated (Appelbaum & Cho, 2009). Meanwhile, the Fed signed off on acquisitions of subprime lenders made by Citigroup and Wachovia, two major financial institutions with global connections. Banks also sought to offset the risks by selling high-risk loans in pools on the markets. Over time, banks began to realize that the housing market was becoming sour, and their losses were starting to pile up.

Further Insights

The Crisis Goes Global

The overwhelming losses affecting U.S.-based financial institutions sent shockwaves around the world. Financial giant Lehman Brothers went bankrupt in September of 2008 and AIG teetered on the brink as well. High-risk mortgages were folded into other pension, mutual, money market and other funds in order to mitigate those dangers. Investors from all over the world were unwittingly made participants in the subprime industry; when the risks came to fruition, investors worldwide experienced losses. In fact, because few understood that the subprime lending industry was so vast and integrated into the securitized market, some investors actually invested more of their money than they had through leveraging; their faith in the marketplace was based on ignorance of the presence of toxic subprime mortgages.

The growing global crisis was exacerbated by the fact that, in the midst of the collapse of Wall Street's biggest figures, short-term lending and capital was nearly halved. New loans to large borrowers fell by 47 percent in the last quarter of 2008 compared to the previous quarter. Lending actually sloughed by 79 percent compared to the height of the "credit boom," which had peaked in 2007 (Ivashina & Scharfstein, 2010). Banks, particularly those that were dependent on credit rather than deposit accounts, were becoming less likely to lend to expanding businesses. On the global stage, monetary policy was extremely loose. Monetary policy that was used in the U.S. to boost consumption after the "dot com" bubble burst during the early 21st century, led to a large number of trade imbalances with emerging market economies like...

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