The rates in the USA over a

The purpose of a full functioning financial system is to
perform the essential function of channelling funds from one group in society
to another that needs it, when financial markets stop functioning it often
causes disruptions that cause asset price declines which lead to economic slowdowns.

The 2008 financial crisis was caused by many factors that will be outlined in
the following discussion to start the discussion it is essential to look at
credit and housing bubble.

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The
Credit and housing bubble – One of the root causes that has often been pointed
out was the prolonged easy monetary policy set by the federal reserve. The USA
over a 10 year period from 1997 to 2007 experienced a period of low interest rates
that had never been set before, to illustrate the changes in the interest rates
below attached it a chart showing the interest rates in the USA over a 10 year
period.

 

 In 1999 rates began
being gradually increased until they reached 6.5% in 2000, rates were cut in
2000 dramatically until they reached lows of 1.0% in 2003. The low interest
rate period encouraged high levels of leveraging by investing with borrowed
money, since it was cheaper for investors to borrow at low rates and invest in
long term high yielding assets such as mortgage backed securities. Mortgage
Backed Securities(MBS) are securities that are created by assembling a large
number of mortgages into pools, the borrowers mortgage payment pass-through a
trustee such as bank or government or bank before being disbursed to the
investors.  The low interest rate period
contributed to the rising housing demand as low interest rates often
incentivise buyers as they have to pay back less on the mortgage rates. The
rising house price led to “financial exuberance” as stated by fed chairman
Allan Greenspan which is when asset prices are driven well above their
fundamental value.

To illustrate the rising house prices attached below is a
chart of house prices over a period from 1997 to 2009.The US S&P
Case-Shiller home price index measures changes in residential home prices in 20
metropolitan cities in the USA.

As interest began falling from 2000 – 2004 there was sharp
rise in house prices which was followed by decline in 2007 that occurred after
a period of rising interest rates from 2004 to 2007. The mortgages would be
packaged into pools that were divided into tranches according to the risk and
return which led to the creation of Collateralized Debt Obligations (CDO’s).

This activity led to the creation of subprime mortgages which were loans made
to borrowers who didn’t qualify due to poor credit rating or low income, there
was an increase in subprime mortgages between 2000 and 2006 from 2% to 17%. As
more people who were previously unable to qualify for mortgages increased so
did demand and house prices increase. The high risk lower low household income
mortgages were rated as safe by Moody’s and Standard and poor, when interest
rates started to rise in 2004 many lower income households were unable to
afford the mortgage thus began to default which led to a decline in wealth from
home equity. As the bubble burst there was no incentive to lend more due to the
increasing interest rate and private institutions became more cautious lending
out as they couldn’t no longer accurately value the mortgage backed securities
forcing them to write of billions off their books with some banks such as
Lehman Brothers and Northern Rock failing.