21.1 Causes of the housing bubble and financial crisis

The housing bubble of the early 2000s was fueled by risky lending practices, complex financial instruments, and lax regulation. Subprime mortgages, mortgage-backed securities, and credit default swaps played key roles in inflating the bubble and spreading risk throughout the financial system.

When housing prices fell, it triggered a chain reaction of defaults, foreclosures, and bank failures. The crisis exposed the dangers of deregulation and the "too big to fail" problem, leading to government bailouts and new financial regulations aimed at preventing future meltdowns.

Housing Bubble and Financial Crisis

Factors in housing bubble

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• Subprime lending expanded high-risk loans to borrowers with poor credit included adjustable-rate mortgages (ARMs) and no-documentation loans (NINJA loans)

• Mortgage-backed securities (MBS) bundled mortgages into tradable assets through securitization process relied heavily on credit rating agencies for risk assessment

• Credit default swaps (CDS) functioned as insurance-like contracts on debt instruments enabled speculation on mortgage-backed securities

• Low interest rates set by Federal Reserve policy post-2001 recession encouraged borrowing and real estate investment

• Government policies promoting homeownership expanded roles of Fannie Mae and Freddie Mac in mortgage market

• Speculation in real estate market fueled house flipping trends and belief in ever-increasing home values

Housing bubble to financial crisis

• Decline in housing prices led to negative equity for homeowners triggered increase in mortgage defaults and foreclosures

• Devaluation of mortgage-backed securities created toxic assets on bank balance sheets eroded financial stability

• Liquidity crisis in financial markets caused interbank lending freeze restricted credit flow

• Collapse of major financial institutions included Bear Stearns rescue and Lehman Brothers bankruptcy shook market confidence

• Credit crunch reduced lending to businesses and consumers hampered economic growth

• Stock market crash wiped out significant value in retirement accounts and investments affected household wealth

• Global economic impact spread crisis to international markets through interconnected financial systems

Deregulation's role in crisis

• Repeal of Glass-Steagall Act removed separation between commercial and investment banking increased risk-taking

• Commodity Futures Modernization Act of 2000 deregulated over-the-counter derivatives market allowed unchecked growth of complex financial instruments

• Inadequate regulation of shadow banking system left hedge funds and private equity firms outside traditional oversight

• Insufficient oversight of credit rating agencies allowed conflicts of interest in rating mortgage-backed securities inflated asset values

• Lack of transparency in complex financial instruments made it difficult to assess true risk levels in financial system

• Limited enforcement of existing regulations due to understaffed regulatory agencies created supervision gaps

• Regulatory arbitrage enabled financial institutions to exploit loopholes and circumvent rules designed to ensure stability

'Too big to fail' implications

• 'Too big to fail' refers to financial institutions whose failure would pose systemic risk to entire economy

• Moral hazard encouraged risky behavior due to implicit government guarantee of bailouts for large institutions

• Government interventions included bailouts of AIG and major banks to prevent systemic collapse

• Taxpayer burden increased as cost of bailouts strained public finances raised questions of fairness

• Market distortions created competitive advantages for large institutions over smaller competitors

• Policy responses included Dodd-Frank Wall Street Reform and Consumer Protection Act aimed at preventing future crises

• Debate on breaking up large financial institutions weighed arguments for and against size limits to reduce systemic risk

• International coordination efforts addressed systemic risk through global regulatory frameworks (Basel III)