Introduction
The 2008 financial crisis is regarded as one of the most severe global economic crises of the 21st century. The crisis affected all the sectors of the economy, similar to the Great Depression. Based on research, the 2008 financial crisis is directly linked to the housing market, which, for many years, had become a symbol of the American dream and prosperity. Homeownership, as will be discussed later, was one of the most debated issues in the 1930s – a time when the U.S. government began embracing the mortgage market.
The issue persisted even after World War II, when veterans started receiving cheap home loans. Policy makers argued that the best way to prevent another war is to ensure that undeveloped land around cities is developed with new housing. The government assumed that buying houses would provide financial security for future generations – but failed to conduct proper risk management.
However, a significant portion of the available research focuses on exploring the political dimensions of the crisis. On the contrary, this review, informed by the existing history of homeownership in the U.S., seeks to describe the common causes of the global financial crisis. To achieve this, 10 sources, predominantly from Google Scholar, were included in this review. The dominant theme in these sources related to the role of the U.S. government.
Government’s Attitude and Regulations
The 2008 financial crisis had a major impact, especially on the banking sector. The government, as explicated by Starr-Glass (2011), moved in with unprecedented bailouts. In addition, the government pumped money into the economy, neglecting the impacts of a decrease in trust on buyer and seller expectations for transactional and relational marketing dynamics (Starr-Glass, 2011, p. 1). The bailouts ultimately sparked a public backlash (Hovie, 2019). In a separate study, Theodore (2020) sought to demonstrate how governments’ decisions in Europe, North America, Asia, and Africa contributed to the escalation of the financial crisis.
These governments moved quickly to stabilize the banking systems by assuming the assets of struggling financial institutions. These moves, as observed further by Coronado et al. (2020), explain why “LAC became slightly more responsive to US EPU shocks after the crisis (p. 1). It is essential to note that the governments in the mentioned countries were accustomed to providing short-term solutions, which explains why the financial crisis persisted for an extended period.
The decision by Congress to loosen banks’ regulatory restrictions has also been cited several times as a contributing factor to the 2008 financial crisis. Most banks expanded their powers and, simultaneously, engaged in risky real estate lending. These powers are the reasons why the banking system embraced the idea of “internationalization and financialization, which drove them deeper into the crisis” (Nelson, 2020, p. 22). In the years leading up to the crisis, Congress made several changes to existing regulations. They included increasing lending standards and capital requirements and “the use of monetary policy as a tool for financial regulation and the classification of systemically significant prices and indices” (Fletcher, 2020, p. 1).
For instance, the Riegle-Neal Act of 1994 removed the restrictions on interstate mergers and branching that had, for many years, prevented banks from acquiring out-of-state banks (Nelson, 2020). Later in 1999, the Gramm-Leach-Bliley Act was passed, which permitted depository institutions to engage in activities with firms that underwrite securities and insurance. These laws were passed to deregulate the banking sector.
In line with the above, the regulatory changes also transformed the banking system into a system of local banks whose primary purpose was to meet the needs of individuals, small businesses, and large banking institutions. The large institutions owned most of the shares of the banking system – this saw them engage in “risky, short-term, fee-generating services (Schuster &Kar, 2021, p. 15).
This, combined with other issues such as deregulation and inaction, triggered the 2008 financial crisis. As Fletcher (2020) accurately observed, the 2008 financial crisis “exposed significant weaknesses and gaps in the regulation of the financial markets” (p. 12). Before the crisis, regulations focused more on the safety and long-term performance of the depository institutions. In the early 2000s, lawmakers started shifting their focus to market contagion and firm interrelations at the expense of financial stability.
The Importance of the Stability of Financial Systems
Lack of financial stability remains one of the highly debated causes of the 2008 financial crisis. The findings in Nagarakatte’s (2019) analysis of eight stock markets demonstrate the importance of financial stability, as the markets considered “were not moving in tandem over the long run” (p. 1). Although several measures have been implemented to mitigate the impact on the stock market, such as those involving Fannie Mae and Freddie Mac, most have failed to address financial instability. Fannie’s mission, as cited in (Reexamination), was “to fund mortgage loans insured by the Federal Housing Administration” (p. 23).
All these efforts were believed to be the solutions that were needed at the time. Hovie (2019) noted that the size and power of financial institutions are critical in relation to government programs. Hovie (2019) argues that the “current options to force the divestiture of banks are inadequate to ensure that no bank is ‘too big to fail’” (p. 1). In fact, programs such as Fannie Mae had outlived their usefulness – they continually changed their objectives to remain relevant.
The high demand for homes led to an increase in housing prices during the second quarter of 2006, triggering financial instability as many people spent more on their assets, which had risen in value. Most people ignored financial stability regulations, which required them to “track leverage used in credit derivatives to determine the effect on money supply in the markets” (Fletcher, 2020, p. 6).
This explains why housing prices continued to rise, leaving financially unstable homeowners unable to sell their property at a profit. Fletcher (2020) described this situation as involving a real estate speculator with many speculative home buyers, accounting for 28% of total sales in 2005. The problem was further compounded by the influx of foreign banks, which led local banks to act as “key nodes for transmitting turbulent conditions in the global financial hubs” (Nelson, 2020, p. 1). As a result, many people began to eschew their loans, with lenders unable to pursue their personal assets.
Importance of Risk Management
Risk management, in this context, involves identifying and evaluating risks and adopting evidence-based measures to minimize their impact. It, therefore, follows that poor risk management was a significant contributing factor to the 2008 financial crisis. According to Schuster and Kar (2021), no one saw the crisis coming – “at every stage, someone was relying on somebody else, and everyone thought they were doing the right thing” (p. 1).
The primary reason no one could see the problem was that measures were in place to identify and mitigate the risk. More specifically, a complex chain of intermediaries existed between the individuals’ purchasing houses and the insurers of these debts. Engaging in risky behaviors, such as reckless financial speculation and unaccountable borrowing, led to the financial crisis.
Congress, on its part, instead of identifying the root cause of the problem, adopted a knee-jerk kind of response to the crisis. For instance, the House of Representatives approved the massive American Housing Rescue and Foreclosure Prevention Act in 2008. The Senate approved it three days later, and on July 30, President George W. Bush signed it into law. The bill ultimately raised the federal debt limit to $800 billion, meaning the overall cost of a federal government rescue plan could easily reach hundreds of billions of dollars.
As further explicated by Farmer (n.d.), the government failed to carry out proper risk management – it ended up identifying high home prices as the disease rather than the symptom. They ultimately provided inaccurate solutions, such as offering easy credit and increased liquidity. The authors compared this approach to the problem of the drug addict situation, where withdrawal symptoms are assumed to be the problem. They end up looking for another drug to fix and resolve the problem, but the problems continue compounding themselves.
Proper risk management is important because it prevents problems from escalating. A good example is when construction firms with poor financial positions (profitability and liquidity) suffered strongly from the crisis due to poor risk management (Chih & Hsiao, 2023). The failure to identify unscrupulous subprime mortgage lenders as the primary cause of the 2008 financial crisis exacerbated the crisis. The lenders, as argued by Farmer (n.d.), “duped gullible low-income and minority borrowers into signing away their financial souls” (p. 5). As previously discussed by Fletcher (2020), high subprime lending was necessitated by the government’s decision to compel banks to loosen their lending standards. The government was concerned more with increasing homeownership for minority and low-income individuals.
Influence on Other Sectors of the Economy
The financial crisis had a major impact on other sectors of the economy, including the construction industry. As observed by Chih and Hsiao (2023), the crisis negatively affected the construction industries of different countries in multiple ways. For instance, construction firms in Malaysia and Australia experienced a significant reduction in profitability due to high labor production costs. The financial crisis had a significant “effect on construction firms’ behavior and performance “(Chih & Hsiao, 2023, p. 2).
In the U.S., the crisis contributed to a deep economic recession, with the unemployment rate increasing from 4.6% to 7.8% between 2007 and 2009, respectively (Chih & Hsiao, 2023, p. 3). The recession further eroded the purchasing power at the household level, ultimately leading to a decline in overall construction demand from the private sector. As a consequence, most construction firms were exposed to fierce competition for new projects, resulting in low profits and a focus on cost-cutting. The firms encountered difficulties when it came to securing loans – many ongoing projects were terminated or abandoned due to a lack of financial support.
Measures to Prevent the Crisis from Happening Again
The Dodd-Frank Act introduced several changes to banking regulations aimed at preventing another financial crisis and the need for endless bailouts of too-big-to-fail banks. For instance, Dodd-Frank responded by increasing capital and liquidity requirements, introducing the Consumer Financial Protection Bureau, and granting regulators the authority to identify, evaluate, and mitigate systemic risk (Hovie, 2019). Moreover, additional financial regulations were introduced to ensure that banks have the amount of capital equivalent to the level of risk on their assets.
This measure was informed by the fact that many banks lacked the required amount of capital to prevent asset losses during the financial crisis. It was understood that the only option was to increase the quantity and quality of capital that banks are allowed to hold. Additionally, the regulators moved to impose stress tests and require a small percentage of the bank’s assets to remain liquid. These measures were intended to ensure that regulators are better equipped to deal with future financial crises.
Conclusion
The sources discussed in the literature emphasized the importance of risk management, government attitude and regulation, and the stability of financial systems in relation to the financial crisis. It became clear from the review that the government responded with unprecedented bailouts, ignoring the root cause of the problem, which, in turn, led to a sharp rise in public debts – politics obscured the debt burden. Similarly, Congress’s decision to loosen banks’ regulatory restrictions contributed mainly to the escalation of the crisis.
In an effort to deregulate banking, laws were passed permitting depository institutions to underwrite securities and insurance. These changes reorganized the system into local banks focused on serving small businesses and individuals. The financial crisis was also significantly driven by financial instability that government programs (e.g., Freddie Mac) could not control. Lastly, a critical factor was inadequate risk management, which Congress failed to correctly identify as the underlying cause.
References
Chih, Y. Y., & Hsiao, C. Y. L. (2023). Brace for another crisis: Empirical evidence from US Construction Industry and firm performance during and after 2007–2009 Global Financial Crisis. Journal of Management in Engineering, 39(1), 402-506.
Coronado, S., Martínez, J., & Venegas-Martínez, F. (2020). Spillover effects of the US economic policy uncertainty in Latin America. Estudios de economía, 47(2), 273-293.
Farmer, B. (n.d.). A Re-examination of the 2008 Financial Crisis.
Fletcher, G. G. S. (2020). Macroeconomic consequences of market manipulation. Law & Contemp. Probs., 8(3), 12-33.
Hovie, L. D. (2019). Breaking up Is hard to Do: Why American Banks remain too big to fail. BCL Review., 60(5), 21-85.
Nagarakatte, S. G., Lovejoy, D. C., &Cheriyan, N. K. (2019). Co-movements between the us and emerging and frontier Asian stock markets: A post subprime crisis analysis. Journal of Academic Research in Economics, 11(1).
Nelson, S. C. (2020). Banks beyond borders: Internationalization, financialization, and the behavior of foreign-owned banks during the Global Financial Crisis. Theory and society, 49, 307-333.
Schuster, C., & Kar, S. (2021). Subprime empire: On the in-betweenness of finance. Current Anthropology, 62(4), 389-411.
Starr-Glass, D. (2011). Trust in transactional and relationship marketing: Implications in a post-crisis world. Managing Global Transitions, 9(2), 111-123.
Theodore, N. (2020). Governing through austerity :(Il) logics of neoliberal urbanism after the global financial crisis. Journal of Urban Affairs, 42(1), 1-17.