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|The decades-long unraveling of the regulatory systems and politic significantly created an environment in which increased speculation in other financial markets and expanded mortgage lending. These factors contributed to the failure of financial institutions such as mortgage firms , insurance companies, and banks followed by the collapse of the market for short-term loans. The impact was felt in the form of a liquidity crisis followed by insolvency and a debt deflation. Ultimately the whole economy sunk into a deep recession.
There are a number of distinct regulatory failures that led to the financial crisis. The first regulatory failure involves the management of U.S trade deficit. Cheap credits characterized by low-interest rates fueled by the housing bubble (Acharya & Richardson, 2009). An excess of capital into the United States from China was one reason for the cheap credit. The U.S. trade deficit was the mirror image of China鈥檚 capital surplus as many U.S. firms sent a lot of dollars to China in exchange for the cheap products sold to consumers.
The second regulatory failure was the reluctance to intervene to pop the Housing Bubble. Federal Reserve policy kept the interest rates at low levels despite the influx of capital. Simple measures could have been taken to thwart further problems. These include changing public perception regarding the future of the housing market. The simple measure could have contained the bubble. However, Federal Reserve Chair declined and denied the existence of a bubble.
The third regulatory failure was Unchecked Financial 鈥淚nnovation鈥?and deregulation. Unregulated mortgage brokers referred to as 鈥減redatory lenders.鈥?This turned the mortgage market on its head. Predatory lenders found a market among government firms and agencies. As of the end of 2008 , the Federal Housing Administration held 4.5 million in Alt-A and subprime loans. Ten million were held by Freddie Mac and Fannie Mae (Goodhart, 2008). Government-mandated loans formed a considerable part of all the junk mortgages in the system. The delinquency rates of these mortgages were substantially greater than comparable rates on prime mortgages.
These mortgages were made available so widely and with non-stringent reviews of recipients鈥?qualifications. This marked a shift in as traditionally, banks made mortgages and held them. In this period, both banks and non-bank mortgage lenders were involved in making loans but then sold the loans to others. Involved banks packaged many mortgage loans into 鈥淐ollateralized Debt Obligations鈥?(CDOs) before selling them to Wall Street , with a guarantee of a stable stream of proceeds from interest payments. These processes were much unregulated. Despite the evident sophistication of the investors concerned, no institution or authority took account of how these loans were being issued or the consequences of such activities.
The fourth regulatory failure was Private Regulatory Failure. Rating agencies such as Moody鈥檚 and Standard and Poor鈥檚 did not assess the CDOs and provide guidance to investors on the nature of risks. They failed completely partly because they wanted to preserve good relations with the investment banks concerning the CDOs.
Additionally, there was a regulatory failure in the controls over Predatory Lenders. The housing bubble and financial deregulation created an environment in which aggressive lenders were able to abuse vulnerable borrowers (Obstfeld & Rogoff, 2009). The terms of the loans didn鈥檛 matter as long as the value of the houses was going up. The lenders presented borrowers with conditions that they could not possibly satisfy , amounting to a dash for foreclosures on subprime loans unavoidable. If such lending practices could have been effectively regulated, it would have prevented the abuse loaning.
Regulations in financial reporting were also blamed for the crisis. In the wake of the crisis, the impact of mark-to-market accounting and fair value measurement on the shares of investment banks such as Lehman Brothers, Bear Stearns , and Merrill Lynch that had issues in mortgage-based securities valuations.
Acharya, V. V., & Richardson, M. (2009). Causes of the financial crisis. Critical Review , 21(2-3), 195-210.
Bordo, M. D. (2008). A historical perspective on the crisis of 2007-2008 (No. w14569). National Bureau of Economic Research.
Goodhart, C. A. (2008). The regulatory response to the financial crisis. Journal of Financial Stability , 4(4), 351-358.
Helleiner, E. (2011). Understanding the 2007-2008 global financial crisis: Lessons for scholars of international political economy. Annual Review of Political Science, 14 , 67-87.
Obstfeld, M., & Rogoff, K. (2009). Global imbalances and the financial crisis: products of common causes.
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