What Caused The Financial Crisis of 2008?

In todays video we will discuss the Credit Crunch, and the role played by credit derivatives and securitization.

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Credit Derivatives and the Financial Crisis of 2007 -2008

What Caused the Financial Crisis of 2008?
Easy availability of credit in the United States, fueled by low interest rates and reduced credit monitoring by financial institutions, led to a housing boom which facilitated debt-financed consumer spending. The existence of credit derivatives and securitization allowed financial institutions to make larger volumes of riskier loans than had been made in the past and consumers assumed an unprecedented debt load.
Between 1998 and 2006, the price of the typical American house increased by 124%. Between 1981 and 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This rose to 4.6 times median household income in 2006.

When home prices declined in the latter half of 2007 and the secondary mortgage market collapsed, a global financial crisis was triggered. Credit derivatives were blamed by many for bringing about this crisis, or for intensifying it.

Credit ratings agencies are widely believed to have failed the markets in their calculations of credit risks on credit derivative products in the lead up to the financial crisis of 2007-2008. They relied on models that were given to them by the credit derivative issuers. The fact that they are paid by the security issuer, rather than the buyer, brought their impartiality into question. There is a structural conflict in this market whereby investors are the beneficiaries or ultimate end users of credit ratings calculations, yet the party paying for the ratings themselves is the issuer.

On the back of the financial crisis, politicians and regulators globally are pressuring originators to resume the former practice of maintaining at least some of the credit risks on the instruments they originate on their own balance sheets. Politicians face a trade-off of hoping to incentivize high consumer spending and home-ownership rates to boost GDP and achieve social goals associated with home-ownership while seeking to avoid the negative outcomes from widespread over-indebtedness from lax credit standards and real estate bubbles. Stronger credit controls stabilize an economy but reduce home values, decrease homeownership levels, and reduce an economy’s GDP growth.