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2007 financial crisis - Essay Example

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Through asymmetric information hence adverse selection, financial crisis was caused by the action and inaction by the government, which created a platform over which both banks taking excessive risks specifically in the mortgage backed security market …
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2007 financial crisis
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2007 financial crisis

The risks kept building up and through the synergistic effect; they interconnected among the institutions, which in the end undermined the stability of the financial institutions. There were seven main causes that worked together to cause the 2007 financial crisis. Such included the securitization of the mortgages bringing forth to the rise in the shadow banking sector, regulatory arbitrage and conflict of interest, leverage and lower interest rates, outsourcing of mortgage broker function, the suits vs geeks’ problem and finally the bankruptcy law changes. The factors mentioned above worked as follows to cause the “perfect financial storm.” (Mishkin 2004) The securitization of mortgages was the first cause of the crisis given that throughout history it had been a trend that mortgages were issued and serviced by the same bank (Mishkin 2004). The government created Fannie Mae and Freddie Mac although both were eventually spun off as private companies to encourage home ownership by creating home loans, which were issued at quiet lower interest rates. These institutions along with other banks converted loans into securities called mortgage backed securities whereby the money paid by the borrower had to pass through the bank to the holder of the security (Mishkin and Eakins 2012). The banks were therefore able to get more funds to issues more loans by selling the loans. The selling of the loans also made them pass the risks associated by the loans to the buyers of the securities whose impacts both tended to reduce the rates of interest on the mortgages (Casti 2012). The two formally created institutions together with AIG and other financial institutions insured those securities against default through credit default swaps, which are just insurances on cars or houses. Securitization of mortgages itself wouldn’t necessarily be unsafe if only low risk mortgages were securitized but the successive administrations went on to encourage Fannie and Freddie to bundle mortgages so as to expand home ownership. Mortgage backed securities are much profitable when there is no default but with defaults insurance payouts grew and the government had to come in to bail out Fannie and Freddie plus AIG (Lounsbury 2010). Mortgage backed security market is part of the broader trend called the shadow banking where firms run from banks to direct finance due to the better rates they are likely to get (Lounsbury 2010). The participants in this sector take a greater risk as this sector is not regulated like the banking sector. These companies also lack the capital requirement that the banks have compounding the risks further so incase of anything these banks lose a lot. Through regulatory arbitrage, capital requirements reappear (Mishkin and Eakins 2012). This act occurs when financial institutions have a way of undermining the intent of regulation to increase profits like the bizarre risk rankings and the shopping for a regulator. Regulatory arbitrage combined together with the conflict of interest contributed to the growing instability of the financial sector. Poor lending practices caused by the changes within the mortgage market was a cause given that the lending authority was given to the independent contractor who were outsourced and being paid on a fee per loan. They therefore had the incentive for loaning people even without looking at their security, which banks could not do as they securitized the loans (The Guardian 2012). Recent government actions like allowing the investment banks to borrow at lower rates so that they could make profits by purchasing MBSs also contributed to the ... Read More
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