The 2008 Financial Crisis: Analysis & Prevention.

In 2008, The United States of America experienced a major recession in the economy. Other parts of the world, including Europe, also faced economic downturn during this period. The United States accounted for about 25% of the world’s gross domestic product (GDP). The primary cause of the recession in the U.S led by the housing crisis, was due to the implosion of subprime mortgage. The housing crisis and the subsequent collapse of subprime lending market was due to the lack of stringent mortgage underwriting guidelines, inadequate controls and risk management, and ethical issues in the value chain including brokers, lenders, credit rating agencies, and consumers.

After the 2001 recession triggered by 9/11 terrorist attacks in the U.S, the Federal Reserve Chairman, Alan Greenspan, and the board of governors, cut the federal rates from 6.5% to 1.75% to stimulate the economy. As interest rates fell, the demand for housing market also started to pick up. The congress in late 90s had directed the U.S Housing and Urban Development (HUD) to enable low income and minority families to get home ownership. As a result of this directive, HUD required that the two government sponsored finance entities (GSEs), namely Freddie Mac and Fannie Mae, should purchase far more "affordable" loans made to these borrowers by various lenders. HUD stuck with an outdated policy that allowed Freddie Mac and Fannie Mae to count billions of dollars they invested in subprime loans as a public good that would foster affordable housing. The housing market was thriving and in 2006, and almost half a billion worth of mortgage bonds were sold by major banks. The agency neglected to examine whether borrowers could make the payments on the loans that Freddie Mac and Fannie Mae classified as affordable. From 2004 to 2006, the two purchased $434 billion in securities backed by subprime loans, creating a market for more of such lending. Subprime loans are targeted toward borrowers with poor credit, and they generally carry higher interest rates than conventional loans.

About three to four million families lost their homes to foreclosure because they could not afford their high-interest subprime loans. Lower-income and minority home buyers -- those who were supposed to benefit from HUD's actions, were falling into default at a rate at least three times that of other borrowers.

Prestigious firms like Bear Stearns was acquired by J.P. Morgan in 2008 and Lehman Brothers had to file for bankruptcy. Several leading financial institutions had to be bailed out with taxpayer money under the Troubled Asset Relief Program (TARP). Housing experts and some congressional leaders now view those decisions as mistakes that contributed to an escalation of subprime lending that is roiling the U.S. economy.

The housing bubble in the U.S. was created due to major flaws in the mortgage underwriting standards such as making loans with no income verification, no major documentation, lower FICO scores, greedy and unethical behavior by brokers, lenders, officials, and consumers, which all contributed to millions of Americans of losing their homes and jobs. The rating agencies did not thoroughly review mortgage-backed securities and subprime bonds and gave them high credit ratings, making them more appealable to investors when in reality they were risky investments. The selling of these risky bonds by major banks were made by Collateralized Debt Obligations (CDOs).

To prevent a similar crisis in the future, key aspects including regulatory oversight, controls, risk management, consumer protection, free market economy, lending standards, and affordability have to be taken into accounts. Consumers should be provided education and literacy on how the mortgage system works, including short, long terms, and adjustable interest rates, and consequences of default.

The proposed solution is to the ensure proper oversight of lenders and lending practices with a regulatory agency such as the Consumer Financial Protection Bureau (CFPB). There should also be proper income verification regarding affordability of mortgage. The brokers, intermediaries, and lenders have to have enough capital to provide cushion in the event of defaults. In the past, brokers could easily qualify a borrower with no documentation and income verification to obtain loans from lenders. These brokers were incentivized to generate business on volume and not necessarily on the credit quality of the borrower. By introducing tighter underwriting standards based on credit quality, affordability to service the debt on a regular basis, better risk management, and classifying the mortgage bonds properly by their credit rating, will be critical in preventing or minimizing losses in the future. The credit score rating process can be improved further to not only indicate the “credit-worthiness” of a borrower but also the ability to service debt over a longer term basis. One can also develop sophisticated analytical tools to determine default risk.

The GSEs have to also ensure that they don’t simply purchase all loans from lenders without proper documentation, checks, and controls. The rating agencies also have to be accountable in their credit evaluation process of mortgage-backed securities. Having correct ratings on mortgage bonds are pivotal because before the 2008 crisis, many AAA to A rated bonds were actually subprime and riskier than a B level bond. If the governments across the globe monitor the lending institutions through regulatory body banks in this way, the chances of witnessing major economic crisis due to housing and mortgage related issues will be mitigated. These should help lower the crisis probability which will also keep inflation in check.