The Subprime Lending Fiasco

The Global Financial Crisis: Explanation, Analysis, and Prevention

The Global Financial Crisis (GFC): Explanation, Analysis, and Prevention

The global financial crisis emerged from a perfect storm of unfortunate variables, some going back decades. While there were many facets of ethics and accountability which played a role, some corporations and their ethical violations, undoubtedly contributed to what came to be known as the Great Recession. This paper will examine the major contributing factors that led to the global financial crisis, the Great Recession, and some considerations for possible prevention of such a drastic recession in the future.

Contributing Factors

In terms of operational risk, the banking sector’s risk management systems concentrated on finances rather than reputation or corporate social responsibility (CSR), and the moral implications were obvious very early (O’Brien, J. 2018). Executives, regulators, and shareholders were most concerned with short-term stock performance and a “poisonous myriad of sub-cultures that operated without credible or external oversight” gave birth to the latest financial catastrophe in recent times (O’Brien, 2018, para. 2). The three lines of defense model, failed to address the true foundation of the problem: toxic subcultures which lacked both credibility and governance (Davies and Zhivitskaya, 2018).

The crisis was centered on the United Sates and the United Kingdom, and both countries favored settlements which did not force banks to admit neither civil nor criminal guilt (O’Brien, 2018). US juror Jed Rakoff termed this lack of admission the “façade of enforcement” (Rakoff, 2014; O’Brien, 2018, para. 6). The Securities Act (1933), the Securities Exchange Act (1934), and the Public Utilities Holding Companies Reform Act (1935), laid the foundation for financial regulations after the Great Depression (O’Brien, 2018). So when the Great Financial Crisis (GFC) threatened key financial institutions and economies, a restructuring took place. The IMF estimated $4 trillion in losses due to the financial crisis (Landler, 2009).

The recovery was largely due to the bailout of banks and similar financial institutions (Landler, 2009). Finance capital, a major factor in the crisis, was strengthened by the bailout, which used with public money of course (Petras, 2019). Petras (2019) discusses the use of the strategic advantage of wealth in a class war against labor for the purpose of continued accumulation of money and capitalist rule (para. 1). The notion of class war, considered by analysts as a “triple crisis” is directly linked to the production crisis in the 1970s (Petras, 2019, para 3). So although there were key factors which occurred during the 90’s, especially in the real estate arena, some variables predate this era considerably.

Of course, Enron, Arthur Anderson, and WorldCom, with their infamous scandals in finance and ethics, also played a role in the GFC. Enron, after concealing billions of dollars in debt, became the largest corporate bankruptcy of the time, leading to the Sarbanes-Oxley Act which increased penalties for defrauding shareholders and altering records in federal investigations, among other things (Sheaffer & Eckhous, 2017; Cohen, 2005). Arthur Anderson LLP, Enron’s accounting firm of the time, committed serious ethical violations in attempting to conceal their fraudulent activity. Then WorldCom notoriously hid $3.9 billion in expenses which lead the Securities and Exchange Commission to charge the telecommunication giant with fraud (Backover & Valdmanis, n.d.). These severe ethical violations raised concern with regulators and with the public. CSR considerations became more and more main stream as people contemplated the consequences lack of ethics and poor corporate behavior can have on the country’s economy, and even the world.

The GFC led to the Great Recession and has forced economists to rethink banking regulations in an attempt to avoid, or manage, similar issues in the future (Clifton, Garcia-Odalla, & Molyneux, 2017). Soft law, or self-regulation, no longer holds the same appeal over hard-law, or legal intervention, now that abusive and opportunistic behavior showed America that self-regulation is morbidly insufficient. To restore consumer confidence, tougher capital and liquidity requirements, to restrict risky banking business, and rules on executive pay were introduced (Clifton et al., 2017). Since 2008, financial system restructuring has occurred globally as well as on the national and regional levels. Clifton et al. (2017) explain how one major trend seen pertained to changes from voluntary codes to legal changes like Basel III (international level), Markets in Financial Instruments Directive (MiFD II) in the European Union, and national incentives such as the Dodd-Frank Act in the United States.

The Great Recession

The Great Recession began in 2007 during President George W. Bush’s administration and ended in June 2009 (Love and Mattern, 2011) and it was considered the biggest American economic setback since the Great Depression in the 1930s (Leguizamon, 2015). In short, overly enthusiastic homebuyers and careless lenders produced a real estate price bubble (Sumner, 2016). Increasing defaults and foreclosures in the subprime mortgage markets, corporate bonds, and commercial real estate are all blamed as recent contributing factors for the recession (Love and Mattern, 2011). With the majority of their assets in mortgage-backed securities, banks were not able to offer further lending to stimulate the economy (Leguizamon, 2015). In the first quarter of 2008 Bear Stearns was sold to JPMorgan Chase, the Treasury Department took over Fannie Mae and Freddie Mac (mortgage industry behemoths), Lehman Brothers failed, and Merrill Lynch sold itself to Bank of America (Love and Mattern, 2011). The Fed (Federal Reserve Board) gathered $85 billion dollars to bail out American International Group, famously “too big to fail” by the end of the third quarter in 2008 (Omarova, 2019, p. 2495). The remaining banks reduced their lending, meaning individuals and business would have difficulty, and considerably more expense, if they attempted to borrow; this quickly caused the Wall Street to nosedive and $8 trillion in wealth was lost (Love and Mattern, 2011). Although the prolific public sentiment of the time was indignation in terms of the bailouts, bank profitability was restored quickly and demand for risky investments, like junk bonds and enormous bonuses for bankers and brokers, was seen again by 2009 (Love and Mattern, 2011).

Whether the blame falls on irresponsible individuals, careless public officials, and/or reckless investors/bankers who exploited market opportunities, deregulation developed into a financial mechanism that drove the banking system into chaos. The real estate market bubble burst when the debt was no longer sustainable. Both the conservative and liberal sides tended to blame individual irresponsibility, like people borrowing beyond their means, and ignored the critical systemic and structural causes (Love and Mattern, 2011).

The True Cause of the Great Recession?

Policy makers may have contributed to the Great Recession with the Community Reinvestment act of 1977 that set artificially low interest rates and allowed banks to make risky loans (Love and Mattern, 2011). The low interest rates were directly correlated to the low mortgage interest rates and did not help debt as Americans took out second mortgages against the equity in their homes. Credit default swaps and collateralized debt obligations created and exploited new opportunities in the market (Love and Mattern, 2011).

Sumner (2016) states the widely accepted theory of the housing market bubble as to the cause of the GR, was actually a distraction from the misguided monetary policy of the Federal Reserve. The Fed disregarded the decrease in nominal Gross Domestic Product (NGDP) which tallies the total amount of goods and services produced in the US, not adjusted for inflation (Sumner, 2016). The idea is that the Fed can control NGDP through policy, and when it fell in 2008, they should have lowered the interest rates quickly, but they kept interest rates elevated for too long out of fear of inflation (Sumner, 2016). In order to prevent a similar, future occurrence the Fed should address NGDP declines, which generally indicate pending inflation, instead of targeting inflation (Sumner, 2016).

A broad spectrum of Economists now support the NGDP-level targeting, with endorsements from highly respected macroeconomists such as Michel Woodford (Professor at Columbia University), Christina Romer (Former chair or Council of Economic Advisers), and Jeffrey Frankel (Council of Economic Advisors member), and even the U.S. Treasury Secretary Larry Summers suggests that closer examination is warranted (Sumner, 2016).

The Lingering Impact of the Great Recession

Glei, Gorldman, and Weinstein (2019) demonstrate widening socioeconomic disparities of economic distress in America that is categorized by “increased distress at the bottom and improved perceptions at the top of the socioeconomic ladder” (para. 1). The effects of the Great Recession endured for even four to five years after its official end, and it undoubtedly contributed to the socioeconomic divide in the U.S. (Glei et al, 2019). Bricker, Bucks, & Kennickell (2011) reported that during 2007 to 2009 one quarter of families lost more than half their wealth. Grusky, Western, and Wimer (2018) argue that the social cost of the recession may extend beyond the economic costs, and that perceptions may even be more significant than objective economic signs.

Prevention?

The complexities of all the contributing factors make it difficult to conclude that these crises can be avoided entirely. Karl Marx explained that capitalism is not only prone to recession, it requires recession (O’Connor, 1988), and this provides insights into one perspective of the nature of capitalistic society. Perhaps recessions are not avoidable, however, unethical behavior and extreme instances of recession, like the Great Recession, could have possibly been alleviated in intensity if there were not so many compounding factors adding to the crisis. Also, of the Fed had responded to the NGDP effectively the blow could have been softened. The roots of the crisis potentially went back generations in decisions, laws and planning. Certainly, no one individual or even group was solely responsible, still all participants could have lightened the impact with ethical behavior and sound financial planning.

The systemic shortcomings of capitalism is such that companies strive to minimize cost, which often is translated into lower wages, and maximize productivity. As workers earn less, they have less to invest into the economy (Doshi, 2019). Debt accumulates and when the system can no longer sustain the burden of debt a correction or recession occurs. Then measures are taken to adjust the system until the next time. While deceitful and greedy brokers and bankers challenge the boundary of what is ethical individuals should shoulder the responsibility, in part, in educating themselves on finances. Policy that aims to reduce debt rather than promote it could have made the recession less severe (Mian &Amir, 2015; Leguizamon, 2015). However, it seems unreasonable to tell those making minimum wage, for instance, not to borrow more than they can pay back for the good of the system. Minimum wage is arguably not even a living wage (Reburn, Moyer, Knebel, & Bowler, 2018). The borrowing likely covers necessities and not extravagance. All while the Forbes list is filled will individuals worth hundreds of billions of dollars (Kroll and Dolan, 2019). Wealthy individuals were less affected by fall in home prices and less likely to change consumption patterns to increases in disposable income (Leguizamon, 2015). The policies enacted to solve the crisis benefited the creditors rather than the borrowers and Mian and Suffi (2015) state that policy makers should have utilized different tools to stimulate spending (Leguizamon, 2015). No, at least part of the answer lies in ensuring living wages are paid to those who provide the foundation of these corporations that are quickly becoming more powerful that most governments. The economy cannot thrive when the majority do not have spending money.

Mian and Suffi (2015) acknowledge that policies implemented which essentially provided additional credit intended to stimulate spending but in actuality the biggest constraint thwarting the economy was demand for goods. Those were most likely to buy products were struggling to keep up with their mortgage payments (Leguizamon, 2015). Mian and Suffi divided the economy into borrowers and creditors, and demonstrated that borrowers have a “higher marginal propensity to consume” (p 2.). The authors conclude that debt reduction would have helped those with the highest marginal propensity to consume and home owners should have been bailed out instead of the banks. Interestingly, they also propose that home financing where the lender and borrower share the risk of falling prices may help to avoid such severe recessions yet to come (Leguizamon, 2015).

Conclusion

The official cause of the Great Recession was addressed respectively and exhaustedly in the media blaming people spending beyond their means and greedy brokers and bankers who took advantage of complexities in the system that laypeople did not understand. Still, would the powers that be disseminate information freely that the Federal Reserve committed the most grievous error? Probably not. All the variables of the equation compound the severity and has taught many important lessons. Individuals need to educate themselves, take measures and carefully plan their finances, bankers/brokers/companies must perform more ethically and with clear accountability, and those in a position of power to change financial policies must remain vigilant and act quickly when indicators in the market point toward recession.

References

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