(i) Major factors causing the 2007/2008 financial crisis

Introduction

The global financial crisis refers to the period of extreme stress in global banking systems
and financial markets during 2007/2008. This financial crisis was a historical systematic risk
event (Ron Rimkus, 2016) and it has thrown the world entered into a severe recession,
making a huge effect among the business and individual around the world (Karl Habermeier,
2010).

The main reasons which caused the financial crisis is the bank change their position from
“originate-to-hold” model to “originate-to-distribute” by issuing securitized products and
sub-prime mortgages, the house-loan borrowers fail to pay their repayment and lead the
market into a housing bubble, raised concerns about the liquidity and solvency of financial
institution, following with the bankruptcy of Washington Mutual, AIG and Lehman Brother
and few financial institutions (Ivashina, 2009). The US government tried to save these
company with taxpayers’ money (too big to fail issue). Furthermore, people lost their jobs
and the world economy gets into panic.

The Major’s Factors

1. Excessive risk-taking in a favourable macroeconomic environment

The period before the global financial crisis, the US’s economic market were growing in a
favourable situation compared to other countries. The economic growth was stable and
strong, the unemployment rate and inflation rate in the US are relatively low. In this
favourable and stable environment, the demand for housing increased rapidly, leading the
house prices grew strongly (Reserve Bank of Australia, 2010). The financial institution
expects that the house price won’t fall and it would rise continuously.
Some financial institution offers plenty amount of mortgage loans to borrowers. Many
lenders even provide housing loans without assessing the borrower’s ability, this included the
“subprime” borrowers who have a higher default risk. Although the borrowers are “risky” but
the financial institutions are willing to take this risk because if the subprime borrowers fail to
pay their loan repayments, the bank can sell the borrower’s house to get back their principal.
At the perception of the bank, they expect that they won’t suffer any losses as they believe
the housing price will rise continuously, seemed the housing market is very profitable at the
time.

2. Securitizing of Loans
The second primary cause of the crisis was the proliferation of securitization. The financial
institution issued a “loan package” called mortgage-back-securities (MBS) (Federal Reserve,
2010). MBS are bonds or securities that derive income from mortgage loans, the lenders pool
these loans together and sell it to investors or trust. The investors believe that this MBS is a
low-risk asset as they assume most of the loan will be repaid. Even though can’t be repaid,
the FI will sell the house and get back the money.
On the other hand, MBS are rated in different grade. Some of the MBS products are rated at a
lower grade. The financial institution created another financial instrument called
collateralised debt obligations (CDOs). CDOs is secured by several underlying assets such as
MBS, corporate loans, leases and etc. The financial institution tried to repackage the low-rate
MBS into CDOs and get a better grade, reselling the MBS in the new form of CDOs (The
Economist, 2013).
Meanwhile, investors found out the CDOs is extremely risky as most of the underlying asset
in CDO is overrated. Hence, a new financial product Credit Default Swap (CDS) is issued by
some financial institution such as AIG (an insurance company in US). CDS is a form of
insurance which allows lenders to insure themselves against the borrowers’ default risk. The
purchaser of CDS has to pay a premium while the seller will pay the buyer if the loan is
defaulted (James Crotty, 2009).

3. Increased Borrowing by Banks and Investors

The investors now are more willing to buy financial products instead of putting their saving
into a bank to get a relative-low rate. Thus, the demand for these financial products increased,
the lenders tried to expand their lending and the investors increasing the amount of purchase
MBS or CDS products. The lenders lend the money to “subprime” borrowers in order to meet
up the demand of the MSB, this sown the seed of global financial crisis.
Borrowing money to buy an asset magnifies the potential of making profit but also magnifies
the potential of suffering losses. As a result, when the house prices began to fall, the lenders
and investors suffered a huge loss as they had borrowed so much.
Additionally, some investors and bank increase to borrowed money for a short period and
purchase the assets that can’t be sold quickly. Consequently, they became reliant on lenders
which extending new loans as existing short-term loans were repaid.

4. Supervisory and Regulatory Factors

Supervision and regulation of the financial system is the responsibility of the government, the
government should discourage excessive risk-taking on the part of the financial institution.
However, inadequate supervision and regulation are the factors causing to this global
financial crisis. The regulation and policy of the subprime lending, MBS, CDOs, and CDS
products were too lax, the financial products became more and more, the amount of these
financial products didn’t get a proper control. Over time, the financial products become more
complex and opaque (Reserve Bank of Australia, 2010).
On the other hand, US’s government drawdowns the credit line of the mortgage loan, leading
the “subprime” crisis which allowed low-credit borrowers to get the mortgage. Besides, the
rating agency overrate these financial products. For example, the lenders repackage the low-
rating MBS into CDOs in order to get a better grade. The rating agency is a private
institution, not a government institution, that’s why most of the CDOs is overrating, this
overrated financial product makes investors are suffering losses (Wallison, 2016).

Conclusion
These factors above causing the global financial crisis in 2007/2008, people suffering losses
from these complex financial products. When the “subprime” borrowers fail to pay the loan
repayment, the bank will sell these house in the market, when the supply of the house
increased but the demand remains the same, the US house price fall. Meanwhile, other
borrowers also defaulted they loan as the house price is not worth anymore. The US house
price fell and borrowers missed the repayment, increasing the stresses in the financial system
in the US, many companies bankrupt, American International Group(AIG) fails to pay all the
CDS and Lehman Brothers suffered a huge loss from these “subprime” borrowing. All of
these problem bunch together leads people losing their jobs and the US economy came to a
rescission and this crisis has spilled over to other countries including Australia.
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