Greg Pettis

February 26, 2021

BUS115470 Introduction to Business (Penny Landuyt) FA16
“What Caused the Financial Crisis of 2008?”
Assignment 1

The financial crisis of 2008 is very comparably the worst economic disaster of the world

since the Great Depression of 1929 - 1942. While most have an opinion of what or possibly

who was the cause of the financial crisis of 2008 by simply boiling it down to greed or economic

down turn. Others including myself feel it was several factors that made the bubble finally

burst namely the housing market and deregulation at the top of the list. The results of rise in

unemployment, toxic loans, housing market collapse, credit default swaps (like insurance

policies issued by banks and taken out by investors) and the increased industrialization of China

all contributing factors setting us up for an economic contraction. It eventually took huge

taxpayer-financed bail-outs to shore up the industry, of which the effects of are still felt in the

market today.

Job loss in the United States during 2008 and in the years following set us up for high

rates of continuous unemployment due to the instability in the financial markets. “In 2008 and

2009, the U.S. labor market lost 8.4 million jobs, or 6.1% of all payroll employment.”

[ CITATION Eco12 \l 1033 ] Government rolls including use of bad assets, monetary policy and

shocks, and that deregulation played a crucial role in the deletions of banks leading up to the

2008 Financial Crisis. The attempt to decrease the government involvement in the financial

system deregulation backfired and was the underlying problem of other potential causes.

Deregulation put depositors, consumers, and banks at risk. The problems that banks faced

include adverse selection, and moral hazard. Moral hazard affects banks because borrowers

may not use the loan for what they indicated they would or perhaps didn’t really qualify for the
 Greg Pettis
February 26, 2021
BUS115470 Introduction to Business (Penny Landuyt) FA16
“What Caused the Financial Crisis of 2008?”
Assignment 1

loan but on paper loan officers made the borrower look really good. A moral hazard occurs

when one person or bank in this case takes more risks because someone else bears the cost of

those risks. One example of a moral hazard leading up to the 2008 financial crisis was financial

institutions' expectations that regulating authorities would not allow them to fail due to the

systemic risk that could spread to the rest of the economy. Financial institutions holding the

loans that eventually contributed to the financial crisis were often some of the largest and most

important banks to businesses and consumers. Borrowers could use the money from the bank

in a way that would put them at a higher risk for default, and therefore, the bank would take on

more risk unknowingly. Simultaneously the large corporations moved some major operations

off shore which highly contributed to the domestic job loss forcing the borrower out of a job.

This in turn caused a slowdown in spending on consumer goods; spending less on clothes and

eating out and more on household fuel bills and healthcare just to sustain a way of life. The

recession and economic slowdown have reduced buying power and consumers tightened their

belts in many ways which crippled an already staving economy. Also, contributing to the

unemployment rate, education of the available work force in the United States is yet another

reason for the unemployment rate going so high. Demand for workers with higher education

also affects the jobs available. “College-educated individuals have the lowest unemployment

rates, and those without a high school diploma have the highest.” [CITATION Lee08 \l 1033 ]

Lower employment rates also lowered the ability for home owners to keep their mortgages.

The Housing and Economic Recovery Act of 2008 in the United States included six separate
 Greg Pettis
February 26, 2021
BUS115470 Introduction to Business (Penny Landuyt) FA16
“What Caused the Financial Crisis of 2008?”
Assignment 1

major acts designed to restore confidence in the domestic mortgage industry. The problem

with that was the loans were no good lenders lending money in a moral hazardous way. Using

a collateralized debt obligation which is a type of structured asset-backed security or the

subprime mortgages used to create the moral hazard. Anyway, these collateralized debt

obligation were originally developed for the corporate debt markets, over time collateralized

debt obligations evolved to encompass the mortgage and mortgage-backed security markets.

With a type of asset-backed security called mortgage-backed security, this is a type of asset-

backed security that is secured by a mortgage or collection of mortgages. The mortgages are

sold to a group of individuals (typically a government agency or investment bank) that

securitizes, or packages, the loans together into a security that investors can buy. The investor

purchases these failing loans secured by the asset and the people in them. The loans were no

good because they were sold to people that couldn’t afford them. Uses of tactics such as

subprime mortgages issued by a lending institution to borrowers with low credit ratings.

Because of the borrower's lower credit rating, a conventional mortgage is not offered because

the lender views the borrower as having a larger-than-average risk of defaulting on the loan.

Also, funny games like 80/20 split mortgages to come up with the 20% down payment, or

interest only loans with 2 – 5 year ARMS. The counties economy was failing and the

outsourcing became the norm.

With the industrialization of China, many U.S. companies have turned overseas as both

a growth market for exports and a market for lower-cost labor for imports and can strategically
 Greg Pettis
February 26, 2021
BUS115470 Introduction to Business (Penny Landuyt) FA16
“What Caused the Financial Crisis of 2008?”
Assignment 1

integrate these into their operations thus taking jobs from the United States, in a process called

“offshoring.” This offshoring is and will continue to be a huge topic in elected officials’ debates

to bring jobs, processes and manufacturing back to the United States to stabilize the financial

market in the U.S. to boost our Gross Domestic Product (GDP) numbers. These financial follies

put a hamper on economic expansion here in the United States. The opposite of economic

expansion was that there was a huge economic contraction because consumers were not

spending, they were cutting back in their budgets to make higher payments on their mortgages

and higher interest loans. This left no room for any disposable income in consumers’ budgets

and in turn caused businesses cut back on production, then lay off workers and the economy

slowed down in fear of spending money they might later need. The unemployment goes up

because businesses cannot keep employees if the business cannot sell their manufactured

products or services to the consumer and it becomes a vicious spiraling cycle that has no end in

sight.

The United States was not a domestic or world producer in this capacity with the cut

backs and clamp on household spending and the health of the economy was failing quickly.

Countries continuously measure the health of their economies to determine whether they are

an expanding or contracting economy. All economies share three goals; growth, high

employment, and price stability. Sometimes additional action is necessary to minimize the

drastic fluctuations in the system to keep things stable. One commonly used measure in the

health of a country’s financial system is the measure of Gross Domestic Product (GDP) which is
 Greg Pettis
February 26, 2021
BUS115470 Introduction to Business (Penny Landuyt) FA16
“What Caused the Financial Crisis of 2008?”
Assignment 1

the sum of all goods and services produced in a country over a period of a year. If GDP goes up,

the economy is growing; if it goes down, the economy is contracting. Another measure is when

the average prices of products either don’t change or change very little, price stability occurs or

Consumer Price Index (CPI). Overall prices go up, we have inflation; when they go down, we

have deflation. By looking at changes in GDP, we can see whether the economy is growing,

stable or shrinking. The CPI allows us to gauge inflation. These measures help us understand

where the economy stands today. But what if we want to get a sense of where it’s headed in

the future? To a certain extent, we can forecast future economic trends by analyzing several

leading economic indicators.

To predict where the economy is headed, we obviously must examine several leading

indicators. It’s also helpful to look at indicators from various sectors of the economy like labor,

manufacturing, and housing. Housing for example and the industry supporting it; the collapse

of Lehman Brothers, a major global bank, filed for Chapter 11 bankruptcy protection following

the massive migration of most of its clients, drastic losses in its stock, and devaluation of assets

by credit rating agencies, largely sparked by the company’s involvement in the subprime

mortgage crisis. A subprime mortgage is a type of mortgage that is normally issued by a lending

institution to borrowers with low credit ratings or borrowers that do not have enough for a

down payment. As a result of the borrower's lower credit rating, a conventional mortgage is not

offered because the lender views the borrower as having a larger-than-average risk of

defaulting on the loan. The flood of irresponsible mortgage lending in America by designing
 Greg Pettis
February 26, 2021
BUS115470 Introduction to Business (Penny Landuyt) FA16
“What Caused the Financial Crisis of 2008?”
Assignment 1

loans to make it easier for low-income families to get mortgages and afford the “American

Dream.” By hiding balloon payments, low interest loans with two, four and five year ARMs

(Adjustable Rate Mortgages) and the promise to refinance into a traditional mortgage in the

future were all major contributing factors of the housing market crash. To complicate matters,

the lending industry was going through a much bigger crisis the same time as these high risk

consumer loans were being sought. One by one, the protections intended to ensure that

lenders didn't write bad loans were removed or circumvented in order to sell that “American

Dream” to folks whom otherwise could not afford the down payment or the higher monthly

payments. The checks and balances to verify income, and the basic interview of an applicant’s

financial stability were tossed aside for quicker or corner cutting ways of undocumented

income so the lender could move volume, post profit and sell the pretty picture of home

ownership to people that would otherwise not be able to afford the house of their dreams.

Then the banks found some creative ways of getting all those risky loans off their balance

sheets by packaging and selling them to investors all over the world but to namely two main

banks offering securities to banks’ lending money so they in turn can make more loans. Rating

agencies like Standard & Poor's essentially told the banks how to structure mortgage-backed

securities in such a way that the agencies could rate them as investment-grade when these

loans weren't even close. And that's pretty much what nearly turned the American subprime

mortgage crisis into a worldwide financial meltdown because borrows could not make the

higher payments when their mortgage payment went up into the higher interest rates after the
 Greg Pettis
February 26, 2021
BUS115470 Introduction to Business (Penny Landuyt) FA16
“What Caused the Financial Crisis of 2008?”
Assignment 1

ARM terms went into effect. Then these practices led to consumer default which also affected

the banks’ ability to borrow. It really opened the door to a string of bankruptcies among

individuals, banks and businesses in US Federal Courts for both Chapter 7 and 11 bankruptcies.

The insurance industry got into the game by trading in “credit default swaps”—in effect,

insurance policies stipulating that, in return for a fee, the insurers would assume any losses

caused by mortgage-holder defaults. “About $900 billion in credit was insured by these

derivatives in 2001, but the total soared to an astounding $62 trillion by the beginning of 2008.”

[ CITATION Joe16 \l 1033 ] This is where the term, "too big to fail" theory asserts that certain

corporations, and particularly financial institutions, are so large and so interconnected that

their failure would be disastrous to the greater economic system, and that they therefore must

be supported by government when they face potential failure. Larger banks like Fannie Mae

and Freddie Mac took a systemic risk and jumped in the game late to protect their profits from

their risky investments. It couldn’t be mitigated through diversification, only through hedging

or by using the right asset allocation strategy. The “too Big to Fail” theory hit them square in

the face. “Nonbank mortgage underwriting exploded from 2001 to 2007, along with the private

label securitization market, which eclipsed Fannie and Freddie during the boom. The vast

majority of subprime mortgages — the loans at the heart of the global crisis — were

underwritten by unregulated private firms. These were lenders who sold the bulk of their

mortgages (toxic assets) to Wall Street, not to Fannie or Freddie. Toxic asset is a popular term

for certain financial assets whose value has fallen significantly and for which there is no longer a
 Greg Pettis
February 26, 2021
BUS115470 Introduction to Business (Penny Landuyt) FA16
“What Caused the Financial Crisis of 2008?”
Assignment 1

functioning market, so that such assets cannot be sold at a price satisfactory to the holder.

Indeed, these firms had no deposits, so they were not under the jurisdiction of the Federal

Deposit Insurance Corp or the Office of Thrift Supervision.” [ CITATION Ste11 \l 1033 ] Some of

us learned the hard way just exactly what and how it was when the housing bubble popped.

The financial crisis measured by its impact on global economy had engulfed the world by

the end of 2008 and has figured to be sharper than any other since the Great Depression. In

comparison with the Great Depression, the two periods had little else in common. However,

the Depression started in the manufacturing sector, while the current crisis had its origins in the

financial sector. There were many contributing factors but one is very clear. Unethical financial

responsibility can make or bring the world economy to its knees.

Works Cited
Denning, S. (2011, November 22). Lest We Forget: Why We Had A Financial Crisis. Retrieved
October 9, 2016, from Forbes:
http://www.forbes.com/sites/stevedenning/2011/11/22/5086/#51eb7d815b56

Economic Policy Institute. (2012, September 4). The Great Recession. Retrieved October 9,
2016, from The State of Working America: http://stateofworkingamerica.org/great-
recession/

Havemann, J. (2016). The Financial Crisis of 2008: Year In Review 2008. Retrieved October 9,
2016, from Encyclopædia Britannica, Inc.: https://www.britannica.com/topic/Financial-
Crisis-of-2008-The-1484264

Mather, M. A. (2008, June). U.S. Labor Force Trends. Population Bulletin 63, no. 2, Population
Reference Bureau.