Step 1

The 2007 financial crisis was caused by the subprime mortgage crisis, which itself was due to the unregulated use of derivatives. Deregulation in the financial sector allowed banks to venture into profitable high risk interest-only loans to subprime borrowers.

Due to adjustable low interest loans and a booming housing market, interest in purchasing homes as investments began rising. Government entities such as Fannie Mae and Freddie Mac guaranteed home mortgages, even if they were lent to people who wouldn’t normally qualify for such loans. These loans were repackaged into mortgaged backed securities(MBS).

The mortgages were valued based on the monthly payments, the total amount owed, the likelihood of repayment, and future home prices by computer models. The banks sold the MBS to other investors such as hedge funds, who sold them on as well claiming they were very safe. Different investors took on the risk of default and they insured their investments through credit default swaps, which were again sold as profitable securities. The MBS had a better credit profile than the underlying mortgages and soon everyone from midsized banks, large investment houses to pension funds owned their own share of the pie.

Step 2

When the Fed raised rates, many subprime borrowers could not repay loans as their interest rates had ballooned, but the low prices of housing meant they could not sell either. As a result, the housing market bubble turned to a bust and along with the original borrowers, hedge funds, banks and other financial institutions that had purchased the MBS all collapsed. With its global reach, the U.S. banking industry almost pulled most of the world’s financial systems to near collapse as well and was saved in the nick of time by a huge bail-out program from the US government.

Large investment banks Bear Stearns, Lehman Brothers and Washington Mutual have disappeared, consumed by their huge MBS defaults. However, companies such as AIG, Bank of America, Citigroup, and other distributors of toxic investments were handed the large sums by the government to offset their massive losses, as they were"too big to fail". The government passed several acts to prevent banks from taking on too much risk and reduce bank size for those that become too big. Tax cuts, stimulus checks, and public works spending all worked in tandem to revive the economy.

Now, more than a decade later, the stock markets are roaring, and with the bailouts returned, the government has made a clear profit. The housing market has recovered and so have the government backed Fannie Mae and Freddie Mac.

Step 3

The impact of the crisis on the economy has been significant. U.S. households lost, on average, nearly $5,800 in income due to reduced economic growth while the combined loss from declining stock and home values totaled nearly $100,000, on average per U.S. household.

The financial crisis cost the U.S. an estimated $648 billion due to slower economic growth, while 5.5 million more American jobs were lost. Income inequality appears to have increased and many who lost jobs during the crisis never recovered.

Discuss the 2007-2008 financial crisis and what impact it had on the financial markets. Who was impacted? What caused the crisis, and how can a future crisis be prevented?

Public Answer