The global financial crisis of 2007-2008, also known as the Great Recession, was a devastating economic event that resulted in the collapse of financial institutions, the bailout of banks, and the worldwide recession that followed. The crisis had far-reaching consequences, including widespread unemployment, a sharp decline in global economic growth, and long-lasting effects on the stability of the financial system. In this explainer, we will examine the underlying causes of the financial crisis, including the role of deregulation, subprime mortgages, and the housing bubble, the financial institutions’ over-reliance on risky investments, and a lack of government regulation.
Deregulation of the Financial Industry
The first major contributing factor to the global financial crisis was the deregulation of the financial industry. In the 1980s and 1990s, there was a significant push to deregulate the financial industry, which led to a relaxation of laws and regulations that had been put in place after the Great Depression to prevent another financial crisis. The deregulation allowed for the creation of new financial instruments and practices, such as derivatives and securitization, which were not subject to the same level of oversight and regulation as traditional banking activities.
The second factor that contributed to the financial crisis was the widespread use of subprime mortgages. Subprime mortgages were home loans given to borrowers with poor credit scores or who had difficulty meeting the traditional criteria for a mortgage loan. These mortgages were typically adjustable-rate mortgages (ARMs), which allowed for lower initial payments but had the potential to increase significantly over time. Subprime mortgages were often packaged together with other mortgages and sold to investors in the form of mortgage-backed securities.
Discriminatory Lending Policies
One of the primary factors contributing to the targeting of minorities with subprime mortgages was predatory lending practices by mortgage lenders. These practices included offering loans with adjustable interest rates that would increase significantly over time, charging high fees and penalties for late payments or early repayment, and making loans with terms that were difficult for borrowers to understand.
The Path to a Housing Crash
According to a 2007 report by the Center for Responsible Lending, 55 percent of subprime loans made between 2004 and 2006 went to borrowers who qualified for prime loans, indicating that lenders were making loans to borrowers who were more likely to default and incur fees.
Discriminatory lending policies also played a role in the targeting of minorities with subprime mortgages. For example, a 2012 report by the National Community Reinvestment Coalition found that Black and Hispanic borrowers were more likely to receive high-cost mortgages than White borrowers, even when controlling for factors such as credit score and income. Additionally, lenders were found to be more likely to steer minority borrowers toward subprime loans, even when they qualified for prime loans.
A lack of regulatory oversight also contributed to the targeting of minorities with subprime mortgages. Prior to the financial crisis, mortgage lenders were subject to relatively little regulation, which allowed them to engage in predatory and discriminatory lending practices without consequence. Additionally, regulatory agencies such as the Federal Reserve and the Office of the Comptroller of the Currency were slow to respond to the growing subprime mortgage market and the risks it posed to the financial system.
The targeting of minorities with subprime mortgages had devastating consequences for borrowers and the broader economy. Many borrowers were unable to make their payments and faced foreclosure, while others were trapped in loans with high interest rates and fees. The resulting wave of foreclosures contributed to the collapse of the housing market and the financial crisis of 2008.
The third factor that contributed to the financial crisis was the housing bubble. In the early 2000s, there was a significant increase in housing prices, fueled in part by the availability of subprime mortgages. Many individuals purchased homes they could not afford with the expectation that housing prices would continue to rise, allowing them to refinance or sell their homes at a profit. However, when housing prices began to decline in 2006, many homeowners found themselves unable to sell or refinance their homes, leading to a significant increase in defaults and foreclosures.
Financial Institutions’ Over-reliance on Risky Investments
The fourth factor that contributed to the financial crisis was the overreliance of financial institutions on risky investments. Many banks and other financial institutions invested heavily in mortgage-backed securities and other complex financial instruments, which were highly leveraged and had the potential for significant losses. When the housing bubble burst, the value of these investments declined sharply, leading to significant losses for many financial institutions.
Lack of Government Regulation
The fifth and final factor that contributed to the financial crisis was the lack of government regulation. The deregulation of the financial industry, combined with a lack of oversight and enforcement, allowed for risky lending practices and the creation of complex financial instruments that were difficult to understand and value. Additionally, government regulators were slow to react to the emerging crisis, failing to recognize the severity of the problem until it was too late.