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Finance & Accounting
Pages 5 (1255 words)
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
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). ...
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