Chapter EMA, Problem 2CYU

To determine

To state: The causes of 2008 financial crises.

Explanation of Solution

The major causes of the 2008 financial crisis are as follows:

The financial crisis was initiated by lax lending standards and cheap credit that caused a housing bubble. When this bubble busted, the banks had trillions of dollars of valueless investments in subprime mortgages. The Great Recession that trailed this financial crisis cost many people their savings, job, and homes.

Reasons include:

1. Extreme risk-taking in an advantageous macroeconomic environment: the economic conditions in the US and other countries were encouraging. Economic growth was stable and strong, and unemployment, rates of inflation, and interest were quite low in the years previous to this one. So, this led to house prices rising powerfully. There was this expectation that the prices of the house would keep on increasing leading households, especially in the United States, to borrow recklessly for purchasing and building houses. So, Banks and other lenders were eager to make gradually more big volumes of risky loans for a variety of reasons.
2. Enlarged borrowing by investors and banks: banks and other investors in the US and abroad borrowed more amounts to enlarge their lending and purchase MBS products. Thus, borrowing money to purchase an asset expands potential profits but also expands potential losses. As a result, when the prices of houses started to fall, banks and investors suffered large losses as they had borrowed so much.
3. Policy and regulation errors: Regulations of subprime lending were too careless. In specific, there was inadequate regulation of the institutions that formed and sold the complex and misty MBS to investors. As the crisis extended, a number of central banks and governments didn’t identify the level to which bad loans had been drawn-out during the period of boom.
4. Crisis as a result of an asset bubble: An asset bubble generally arises when the asset price, such as bonds, stocks, commodities, or real estate, increases at a fast pace without underlying fundamentals, such as correspondingly fast-rising demand, to validate the price rise.

Economics Concept Introduction

Introduction:

Financial crisis: is often regarded as a mixture of events, including considerable changes in asset prices and credit volume, severe disturbances in financial intermediation, large-scale balance sheet difficulties, especially the supply of external financing, and the requirement for large-scale government help.