Answer to Question #306778 in Management for Dee Park

Question

Discuss the main causes of the financial crisis in 2008? Identify the main risks that contributed to the crisis!

At least 6-8 pages (100 marks)

Answer 1

The supply of houses outran demand, borrowers defaulted on their mortgages, and the derivatives and all other investments tied to them lost value. The financial crisis was caused by unscrupulous investment banking and insurance practices that passed all the risk to investors. The key causes were;

1. Immoderate investments and deregulation

The two decades before the Great Recession were largely prosperous, with rises in GDP, low inflation, and two relatively mild recessions. 

2. Loose lending standards in the housing market

In the decade leading up to 2007, real estate and property values had been rising steadily, encouraging people to invest in property and buy homes. By early to mid-2000s, the residential housing market was booming. To capitalize on the boom, mortgage lenders rushed to approve as many home loans as they could, including to borrowers with less-than-deal credit. 

3. Risky Wall Street behaviour 

Along with issuing mortgages, lenders found another way to make money off of the real estate industry: By packaging subprime mortgage loans and reselling them in a process called securitization. Through securitization, subprime lenders bundled loans together and sold them to investment banks, which, in turn, sold them to investors around the world as mortgage-backed securities (MBS). 

4. Weak watchdogs

Like corporate bonds and other forms of debt, MBS and CDOs required the blessing of credit rating agencies in order to be marketed. The "Big Three" credit rating agencies include Moody's, S&P, and Fitch Group. These agencies placed AAA ratings usually reserved for the safest investments on many securities, even though they contained a healthy share of risky mortgages.