Running head: FINANCIAL CRISIS OF 2008 1

Financial Crisis of 2008

Momodou Jallow, Khongorgerel Gankhuu & Jeff Price

Park University

12/2/2019.
FINANCIAL CRISIS OF 2008 2

Financial Crisis of 2008

The 2008 financial crisis resulted in the total collapse of Lehman Brothers as well as the

near-collapse of several U.S. and global financial institutions. This economic crisis was thwarted

by the subsequent bailout of big business and banks by national governments. The crisis played a

significant role in bankrupting essential businesses and causing a downturn in economic activity

leading to global recession. In many parts of the United States, housing markets suffered,

resulting in evictions, foreclosures and hard times for many Americans.

Senate Financial Crisis Report (2011). In the months following the financial crisis,

monetary reforms were enacted by the U.S. Congress to prevent the possibility of another failure

of financial collapse. In July 2010, the Dodd–Frank regulatory reforms were enacted in the U.S.

to lessen the chance of a recurrence (Paletta, D.; Lucchetti, A., 2010.) Th

Causes of the Financial Crisis

Unlike previous bust and boom cycles of the past, the crisis was caused as a result of

toxic “complex financial products, faulty credit-rating agencies, and failure of the regulators, as

well as the market itself to restrict the excesses of Wall Street” (Senate Financial Crisis Report,

2011). Senator Levin, who chaired the Senate Levin-Coburn Report noted that “The

overwhelming evidence is that those institutions deceived their clients and deceived the public,

and they were aided and abetted by deferential regulators and credit-ratings agencies, which had

conflicts of interest” (Senate Financial Crisis Report, 2011).

As part of the housing and credit booms, the number of financial agreements called

mortgage-backed securities (RMBS) and collateralized debt obligations (CDO), which derived

their value from mortgage payments and housing prices, greatly increased. These were the toxic

products that accelerated the bust cycle as unqualified buyers who were saddled with adjustable-
FINANCIAL CRISIS OF 2008 3

rate mortgages. Home owners had a financial incentive to enter foreclosure as the falling home

prices also resulted in homes worth less than the original mortgage loan. Prices and trading

volumes in mortgage-backed securities shrank significantly. As the reluctance to lend, spread to

other markets, the U.S. economy entered a lengthy recession.

U.S. sub-prime lending as well as easy credit conditions provided evidence that

competitive pressures contributed towards an increase in the amount of sub-prime lending during

the years prior the crisis. Major U.S. investment banks and government-sponsored enterprises

like Fannie Mae played an important role for expansion of lending, with GSEs eventually

relaxing their standards to try to catch up with the private banks. (Wall Street and the Financial

Crisis: Anatomy of a Financial Collapse. 2011 p. 10)

Depending on how sub-prime mortgages were defined, they remained below ten percent

of all mortgage originations until 2004, when they spiked to nearly twenty percent and remained

there through the 2005–2006 peaks of the United States housing bubble (Wall Street and the

Financial Crisis: Anatomy of a Financial Collapse. 2011 p. 12). As of March 2011, the FDIC paid

out nine billion dollars to cover losses from the bad loans of 165 failed financial institutions. The

Congressional Budget Office estimated in June 2011, that the bailout to Fannie Mae and Freddie

Mac exceeded three hundred billion dollars. (Fried, J, 2012)

Housing Bubble

The price of the typical American house increased by one hundred twenty percent

between 1998 and 2006. During the two decades ending in 2001, the national average home

price ranged from 2.9 to 3.1 times average household income. This ratio rose to 4.0 in 2004, and

4.6 in 2006. This housing bubble resulted in many homeowners refinancing their homes at lower

interest rates, or sponsoring consumer spending by taking out second mortgages secured by the
FINANCIAL CRISIS OF 2008 4

price appreciation. The collateralized debt obligation, in particular, enabled financial institutions

to obtain investor funds to finance sub-prime and other lending, extending or increasing the

housing bubble and generating large fees. This essentially places cash payments from multiple

mortgages or other debt obligations into a single pool from which specific securities draw in a

specific sequence of priority. Those securities first in line received investment-grade ratings from

rating agencies. Securities with lower priority had lower credit ratings but theoretically a higher

rate of return on investment.

Origins of the Financial Crisis

In September 2008, the collapse of Lehman Brothers almost brought down the world’s

monetary system. It took massive taxpayer bail-outs to shore up the industry. Even so, the

ensuing credit crunch turned what was already a vicious downturn into the worst recession in

eighty years. The recovery remained weak compared with previous post-war upturns; only

massive monetary and fiscal stimulus prevented a major depression.

Folly of the Financiers. The years before the crisis saw a flood of irresponsible

mortgage lending in America. Loans were doled out to sub-prime borrowers with poor credit

histories who struggled to repay them. These risky mortgages were passed on to financial

engineers at the big banks, who turned them into supposedly low-risk securities by putting large

numbers of them together in pools. Pooling works when the risks of each loan are uncorrelated.

The pooled mortgages were used to back securities known as collateralized debt obligations

(CDOs), which were sliced into tranches by degree of exposure to default. Investors bought the

safer tranches because they trusted the triple-A credit rating assigned by agencies such as Moody

and Standard & Poor. This was another mistake. The agencies were paid by, and so indebted to,

the banks that had created the CDOs.

Regulators. Failures in funding were at the heart of the crash. However, bankers were

not the only people to blame. Central bankers and other regulators bear responsibility too, for

mishandling the crisis, for failing to keep economic imbalances in check and for failing to

exercise proper oversight of financial institutions. The regulators’ most remarkable error was to

let Lehman Brothers go bankrupt. This multiplied the panic in markets. Quickly, nobody trusted

anybody, so nobody would lend. Non-financial companies, unable to rely on being able to

borrow to pay suppliers or workers, froze spending in order to hoard cash, causing panic in the

real economy. Unfortunately, the decision to stand down and allow Lehman to go bankrupt

resulted in more government interference. Regulators had to rescue scores of other companies to

stem the following panic.

Effects of The 2007-2008 Financial Crisis

To Firms:

Using a supplier–client matched sample, we study the effect of the 2007–2008 financial

crisis on between-firm liquidity provision. Consistent with a causal effect of a negative shock to

bank credit, we find that firms with high liquidity levels increased the trade credit extended to

other corporations and subsequently experienced better performance as compared with ex ante

cash-poor firms. Trade credit taken by constrained firms increased during this period[ CITATION

Gar13 \l 1033 ]. These findings are consistent with firms providing liquidity insurance to their

clients when bank credit is scarce and offer an important precautionary savings motive for

accumulating cash reserves[ CITATION Gar13 \l 1033 ].

To Systemic Trust:
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The collapse of Lehmann Brothers in mid-September 2008 had an enormous impact on

the financial markets and the global economy by undermining trust – trust in counterparties

among banks and trust in the overall stability of the financial system, but also citizens’ trust in

their institutions – systemic trust – and the validity of the underlying principles[ CITATION

Rot09 \l 1033 ]. It is thus not surprising that re-establishing trust in the financial system has

become a key task for policymakers throughout Europe (and the USA). Studies aim to contribute

to the ongoing discussion of the impact of the financial crisis on trust by presenting recent

empirical results concerning the reaction to the crisis as reflected in citizens’ diminished levels of

systemic trust. Within the paradigm of systemic trust, special attention is given to the confidence

invested in:

i) political institutions at European and national level and

ii) ii) the free market economy[ CITATION Rot09 \l 1033 ].

Researchers first briefly elaborates on the key role of systemic trust and cites some basic figures

concerning public demand for more state intervention. Using time series data1 from the public

opinion monitoring unit of the European Commission (Eurobarometer), the consequences of the

financial crisis on public opinion vis-à-vis the three major European institutions: The European

Central Bank, the European Commission and the European Parliament are then demonstrated.

This is followed by an examination of the relationship between European and national

institutions using time trend data on trust towards national governments and national parliaments

from Eurobarometer and the Edelman Trust Barometer. Finally, cross-country results for the five

largest European economies and the USA and time trend data for Germany are presented to

demonstrate how the confidence levels in social market economies per se have been falling after

the financial crisis[ CITATION Rot09 \l 1033 ].

The Key Role of Sufficient Levels of Systemic Trust Social scientists from all fields

agree that a sufficient level of trust, especially systemic or institutional trust, plays a crucial part

in the stability and maintenance of the social, political and economic system. When trust breaks

down, the social system is threatened with unrest, the democratic legitimacy of the political

system is endangered, and the legitimacy of the market-based economy is called into question.

The latter should be mentioned in particular. Citizens’ loss of confidence in a market-based

economy is often expressed in one of two ways. They pressure the government either to abolish

the free-market system altogether or to intervene more heavily in the system. The likelihood of

the first scenario materializing is rather small, as polls taken in the world’s largest economies

indicate that a majority of citizens are still content with a market-based economy. In some

economies, however, notably Germany, anti-capitalist sentiments are growing

stronger[ CITATION Rot09 \l 1033 ]. According to a GlobeScan survey conducted in May-

August 2007, a significant decrease in the confidence in free market economies had begun as

early as 2002 in Germany, the USA, the UK and the emerging economies. The second scenario

in fact is more realistic, as evidenced by increasing calls for stronger state intervention. Citizens

want more state intervention at the national and regional level and less integration of their

economies in a more globalized context. Recent polls suggest that globalization is seen as a

threat by citizens throughout the world[ CITATION Rot09 \l 1033 ].

According to the Edelman Trust Barometer4 conducted in January 2009, for instance, 65% of all

respondents (a figure that rises to 84% in France) agreed that their government should impose

stricter regulations and greater control over businesses in all industries. According to an

FT/Harris Poll from mid-October 2008, 81% of Italian, 70% of German, 68% of French and 59%

of British respondents support increased regulation by their governments of businesses’

activities. Citizens had expressed strong fears about globalization even before the financial

crisis[ CITATION Rot09 \l 1033 ].

A GlobeScan survey conducted shortly before the financial crisis erupted indicated that a

majority (72%) of respondents in 23 countries were in favor of measures to protect jobs and

national industries, and 63% overall favored restricting foreign ownership of national companies[

CITATION Rot09 \l 1033 ]. And according to an FT/Harris Poll in March 2009, already more US

citizens tend to agree (30%) than to disagree (24%) that national protectionism is the correct

instrument to end the economic recession. Evidence from Eurobarometer One of the crucial

research questions emerging from the ongoing crisis is how strongly the crisis is affecting

European citizens’ level of confidence in various institutions. The collapse of the financial sector

has made European citizens aware of the fact that capitalist systems are more fragile than they

believed they were. Time trend data on confidence levels are still scarce, but one possible source

are the survey findings released by Eurobarometer (EB) on the European and national

institutions. Thus, to answer the important question on the evolution of European citizens’

confidence levels, time series data from EB have been utilized to show the trend in trust for the

EU15 and, starting in spring 2007, for the EU27, regarding: • the European Central Bank (ECB)

• the European Commission (EC) • the European Parliament (EP). Figure 1 shows the time trend

in net levels of trust8 in the European Central Bank for the 12 member states of the

eurozone[ CITATION Rot09 \l 1033 ].

To Financial Institutions:

Studies investigate the influence of corporate governance on financial firms' performance

during the 2007–2008 financial crisis. Using a unique dataset of 296 financial firms from 30
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countries that were at the center of the crisis, researchers find that firms with more independent

boards and higher institutional ownership experienced worse stock returns during the crisis

period. Further exploration suggests that this is because (1) firms with higher institutional

ownership took more risk prior to the crisis, which resulted in larger shareholder losses during

the crisis period, and (2) firms with more independent boards raised more equity capital during

the crisis, which led to a wealth transfer from existing shareholders to debtholders. Overall, our

findings add to the literature by examining the corporate governance determinants of financial

firms' performance during the 2007–2008 crisis[ CITATION Erk12 \l 1033 ].

 Firms with higher institutional ownership performed worse during the crisis.

 Institutional ownership was associated with greater risk-taking before the crisis.

 Firms with more independent boards performed worse during the crisis.

 Board independence was associated with more equity raisings during the crisis.

 Equity capital raisings helped firms survive the crisis[ CITATION Erk12 \l 1033 ].

Recommendation

The underlying causes of the financial crisis are anything but simple, and the extent of the effects

may not be fully realized for years to come. There were several key indicators which should have

been identified early enough to prevent markets from crashing and bringing the global financial

system to a screeching halt. Financial institutions were originating mortgages at a record pace,

the marketplace was being injected with highly risky and extremely volatile instruments which

had not been properly evaluated by regulators, and liquidity levels were anything but certain.

Additionally, the crisis was exacerbated by the fact investors and institutions were unprepared for

the losses which ensued (Lo, 2009). In response to the crisis, central banks intervened, and
FINANCIAL CRISIS OF 2008 10

regulatory reform was enacted to try and prevent further collapse. The short-term adjustments

made to the financial system at the time of the crisis were reactionary in nature; however, there

must be several system-wide, long-term changes implemented throughout the economy to ensure

a similar crisis does not happen again. There must be more transparency in the financial markets,

regulatory reform must be integrated within the regulatory structure, and corporate governance

must encompass an enterprise-wide risk management approach. By incorporating forward-

looking financial tools with a holistic approach to corporate governance and oversight, financial

institutions will be better prepared for the next financial crisis.

In order to effectively manage systemic risk, financial markets must become more

transparent (Lo, 2009). By providing more transparency, the market will produce more efficient

prices, and the market will allocate capital and other limited resources more effectively (Lo,

2009). In the case of the 2007-2008 financial crisis, pertinent information was not always

provided to the market, which in turn left participants to infer what they could from the limited

information that was available (Lo, 2009). The lack of transparency played a bigger role in how

the market determines prices and quantities (Lo, 2009). Comprehensive data is an essential

component when trying to draw conclusive inferences about systemic risk in the financial sector

(Lo, 2009). Without a full understanding of a company’s characteristics such as: assets under

management, leverage, counterparty relationships, and portfolio holdings, inferences surrounding

systemic risk are indirect and circumstantial (Lo, 2009). Although banks and other regulated

financial institutions provide this information, the “shadow banking system” does not, and

without access to data from hedge funds, their brokers, and other counterparties, it makes

deriving actionable measures of systemic risk nearly impossible (Lo, 2009). The effects of a

financial crisis can be significantly reduced by ensuring the appropriate parties are bearing the
FINANCIAL CRISIS OF 2008 11

appropriate risk (Lo, 2009). This can be achieved through greater transparency, along with the

expertise to make use of the pertinent information (Lo, 2009). By facilitating access to

information and education, many of the problems posed by financial excess could be solved by

market forces and private enterprise, which could prove to be more efficient and effective than

government intervention (Lo, 2009). In addition to facilitating information and education, the

financial industry must re-consider the tools being used to evaluate systemic risk. Specifically,

the generally accepted accounting principles (GAAP) accounting methods, which are primarily

used in the corporate decision-making process and as a regulatory requirement (Lo, 2009). This

method is considered backward-looking by definition and is not ideal for providing risk

transparency (Lo, 2009). Therefore, a risk-based accounting method could be used to more

accurately measure and manage systemic risk on a global scale (Lo, 2009). However, increased

transparency in the financial market does not come without risk. With the advent of institutions

utilizing highly complex and sophisticated algorithms, there is proprietary information and legal

recourse to consider prior to calling for full transparency. Ultimately, financial institutions must

provide greater transparency for participants in order to help facilitate effective regulatory

reform.

The underlying objective of effective regulatory reform is to efficiently reduce the chance

and cost of future systemic crises without compromising economic growth or general welfare

(Claessens & Kodres, 2014). Additionally, policy makers must think holistically when engaging

in their risk monitoring efforts and financial system reforms (Claessens & Kodres, 2014). The

financial crisis of 2007-2008 demonstrated how systemic risks can go undetected or not

addressed for an extended period of time and result in significant harm (Claessens & Kodres,

2014). The reform efforts must examine interactions between and across institutions, markets,
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participants, and jurisdictions across various types of risks (Claessens & Kodres, 2014).

However, there must be acknowledgment to the fact institutional, political, and other constraints

will likely affect the reform, and the degree to which regulations are actually enforced (Claessens

& Kodres, 2014). Furthermore, due to the aforementioned constraints, financial crises will likely

recur (Claessens & Kodres, 2014). In order to minimize the effects of a future crisis, a system-

wide perspective entailing public financial stability reviews and large scale stress tests should be

used by supervisory agencies as a part of a broader process (Claessens & Kodres, 2014). The

system-wide view will aid in supervision, as well as the design of future regulations (Claessens

& Kodres, 2014). Current regulation is largely designed from a micro-prudential perspective, and

this approach can make the system more risky, even when it is well-designed (Claessens &

Kodres, 2014). In order to reduce the risks of a crisis, there must be a system-wide perspective

encompassed with a macro-prudential toolkit, and institutions should be required to assure the

necessary remedial actions (Claessens & Kodres, 2014). One way to ensure an effective system-

wide reform is to incentivize direct market participants to play an active role in creating a safer

financial system (Claessens & Kodres, 2014). Rather than being prescriptive in the messaging,

provide market participants with the possible gains and losses they face, including the chance of

sanctions for criminal wrongdoings, and the incentives could dictate agents to appropriately

manage risks and serve as mechanisms to absorb shocks in the market (Claessens & Kodres,

2014). By creating incentives through regulations and policies, the more likely this approach will

bring about a more efficient and stable financial system (Claessens & Kodres, 2014). However,

the manner in which these incentives are derived should fall within the construct of system-wide

regulatory reform. Additionally, the extent of incentives must be closely monitored through
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regulatory oversight, as well as appropriate corporate governance to ensure reform doesn’t turn

to excess.

Historically, the corporate governance structure has been viewed as a public relations

tool, or a marketing structure as opposed to serving its true purpose of being a watchdog for the

shareholders’ benefit (Lo, 2009). In order to change the perception, corporations should consider

developing a formalized enterprise risk mandate which outlines specific benchmarks for

measuring enterprise risks and acceptable limits, and targets for each of the defined risks (Lo,

2009). Additionally, this mandate should be reviewed and approved by the board on an annual

basis, and updated based on any material changes in the enterprise risk or market conditions (Lo,

2009). Corporations could create a senior management position to help oversee the development

and implementation of the mandate. The appointee would report directly to the board, and the

structure of the position’s compensation should be based on maintaining corporate stability,

instead of profitability or growth (Lo, 2009). Furthermore, the individual responsible for

ensuring corporate stability must be granted authority, in writing, to conduct monthly risk

estimates, which should be provided to the board and senior management (Lo, 2009). The new

position will help to create a balance between the corporation’s inclinations to take on risks and

the need for self-preservation (Lo, 2009). Moreover, by creating an independent position, the

corporation creates a self-regulating mechanism to help resolve conflicts of interest which may

arise between directors disputing the magnitude of business opportunities forgone and the

magnitude of enterprise risk that may be created (Lo, 2009). Despite the severity of the 2007-

2008 financial crisis, naysayers will argue a system-wide reform will infringe upon proprietary

competitive advantages, and existing market mechanisms are fully capable of managing risks

internally. Additionally, the harsh reality is, financial losses are unavoidable. However, with
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financial turmoil and devastation come opportunities for innovation and reform. By increasing

market transparency, integrating regulatory reform within the regulatory structure, and enhancing

corporate governance, the global economy will be better situated to reduce the impact of the next

financial crisis, not if but when it happens.

Conclusion

The housing boom cycle and the financial meltdown arose from market conditions

created by the Federal Reserve, the government backing of Fannie Mae and Freddie Mac, the

Department of Housing and Urban Development and its Federal Housing Administration. As for

decisions made by the guilty financial institutions, the traditional solution for severely flawed

investment policies is to shut them down and shutter those firms. “Too big to fail” is an

oxymoron that suggested the United States taxpayers are too dumbed-down to say “NO” to

misguided firms when they get themselves in a jam and expect to get bailed out. That sort of

market reorganizing should have never been allowed to happen in the U.S. financial sector. A

financial market in which monstrous enterprises like Freddie Mac and AIG, that are never shut

down, are like those unwelcome six hundred-pound gorillas that never go away.

The closure of Lehman Brothers by raising the interest rate that the market charges to

highly leveraged investment banks, forced Goldman Sachs and Morgan Stanley to change their

business models drastically. The most effective and appropriate form of business regulation is

regulation by profit and loss. If you are smart, you win, if you are unwise, you lose! The same

goes for the severely mistaken government monetary and regulatory policies that have plagued

this nation for the last seventy years. It is necessary to identify and undo policies that distort

housing and financial markets, and dismantle failed agencies and departments, such as Housing

and Urban Development, whose missions require them to alter markets.

We should recognize the three chief errors that were made. First, to never again allow

banks to delve into financial markets that allow them greater opportunity to take advantage of the

unsophisticated public. Second, to control the cheap-money policies of Federal Reserve and

better yet revamp the Federal Reserve, which is about as Federal as Federal Express. Third, stop

our failed politicians from delivering mortgage subsidies by imposing affordable housing

legislation on banks and by providing federal support to Fannie Mae and Freddie Mac bonds that

can fail in such a disastrous way that it harms the U.S. economy. The U.S. recession that began

in December2007 ended in June 2009, according to the U.S. National Bureau of Economic

Research (NBER) September 20, (2010) announcement of June 2009 business cycle through/end

of last recession.
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