Robert Kuhn
Money and Banking Term Paper
Dr. Wansi
5/7/2015
A financial crises is when a number of factors lead to a group of important financial assets such as stocks, bonds, or even currency lose their value in a short and usually unexpected time. These crises are usually precipitated by mistakes and people overlooking very key economic indicators. When a financial crises hits our nation or really any nation there are feelings of uncertainty and stress among investors and citizens alike because the uncertainty that can come with a crises affects everyone, rich and poor.
The most recent financial crisis in the United States was the 2008 bursting of the home loan/mortgage bubble. There were many different factors that led to this perfect storm of financial problems but at the heart of the entire crisis were the changes that took place in our banking system, and more specifically, changes that were made to the process and eventual determination of who could receive home loans. Prior to the year 2000, only people with excellent credit ratings and payment histories could receive home loans. The changes in the process for determining who’s loan requests would be approved began with the realization by people in the banking industry that they could use technology and computers to mine data about potential borrowers that was supposed to give deeper insight as to their ability to repay loans, this data went further than the tried and true method of using credit scores. Bankers began using a numeric scale called the FICO scale to determine who would receive loans. Instead of these scores being based upon strong indicators like credit rating and payment history, these scores were directly tied to the data that was mined and processed through algorithms that were supposed to find solid loan applicants inside groups of people that previously would have been denied. Data mining combined with the new practice of combining smaller loans like these mortgage loans together and turning them into standard debt securities that were more easily handled by the banks. All of this led to a greater number of banks giving loans without doing the proper homework.
To make things worse, an influx of liquidity in our nation due to loans from countries like China and India helped the housing market take off; raising the prices of homes to new levels and making the people who took these loans feel even brasher about borrowing money that they did not have. With this new system in place, borrowers began to realize that they had very little at stake in taking these loans, most figured that the housing market would continue to rise or at least stay at the high place that it was, and others realized that they could walk away from their loans and homes if the market dropped and their houses values became lower than the loans that were taken to buy them.
Hedge funds or Brokerage Houses were also to blame; they began using repurchase agreements that were backed by the debt securities that were made up almost entirely of risky loans. Leading up to 2008 the inflated level of the housing market began soaring back to earth. Borrowers were forced to give up their homes and even more troublesome, these hedge funds were now forced to sell off these packages of loans for next to nothing. At the peak of the crisis the United States began to see things that it hadn’t seen since the great depression: some of the most highly respected and tenured (some up to 100 years) realized that they were broke. Bear Sterns, one of the most historically respected investment houses was forced to sell itself, Lehman Brothers filed for bankruptcy and many others were in the same position. This now meant that not only the housing market was in trouble but our entire economy was in jeopardy because of the stabilizing role that these large companies used to play disappeared. The Fed handled this crisis with magnificent fashion. The Fed Chair Ben Bernanke realized that the
