The 2008 financial crisis also known as “The Great Recession” is considered the worst economic collapse in modern history. It originated due to significant mismanagement and abuse of the financial market, primarily due to the use of subprime mortgages. Despite numerous regulatory measures in place, the federal government and market control mechanisms were unable to prevent it. It led to a drastic re-examination of financial policies and the introduction of new legislation as a response to address various aspects of the economy that caused the recession. This paper will seek to investigate the origins of the 2008 financial crisis and the resulting policy shifts to manage the economic markets.
The biggest causative factor of the Great Recession was deregulation. The Gramm-Leach-Bliley Act of 1999 repealed an earlier law and allowed banks to use deposits as an investment tool for derivatives. In 2000, the Commodity Futures Modernization Act deregulated credit default swaps and many other derivatives. The Gramm-Rudman Act further liberalized bank engagement in trading derivatives that were sold to investors.
However, these derivates and securities commonly required mortgage-backed home loans as collateral (Amadeo, 2018a). As a result, there was an increased demand for mortgages from financial organizations, leading to them simplifying the requirements to receive such loans.
Furthermore, the earlier mentioned laws essentially equalized privately issued mortgage-backed securities with government-issued mortgages, making them both low risk. As a result, the market was filled with mortgages that would have been usually deemed as high risk. Lower credit standards, poor regulation, and abuse of high-risk assets eventually led to a pyramid-like system of instability, high consumer debt, and inflated home prices (Michael, 2015). Eventually, the system began to implode, as homes and derivatives lost value while financial institutions began to panic and cut off money flow as there was a realization that losses will have to be absorbed.
One of the most well-known financial, legislative regulations of the post-crisis period is the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The law was a comprehensive effort to implement massive regulations on financial institutions and markets as well as establishing consumer protections, particularly from predatory mortgages. Major aspects of the act focus on bank reform, including action plans in case of potential bankruptcy and reserve funds for future recessions to prevent collapse.
Large banks must undergo evaluation and stress tests by the Federal Reserve and Financial Stability Oversight Council. A sub-provision known as the Volcker Rule prevents banks from making investments such as hedge funds on their own accounts. Furthermore, the act protects the consumer by regulating corrupt business practices and purposefully high-risk lending which protects the consumer (History.com, 2018).
Overall, the legislation covers all aspects of the financial system, from executive compensation and security exchange to management of credit ratings and loan distribution. Particular attention was aimed at asset-backed securities and derivative swaps. Even insurance companies are regulated to ensure that both banks and consumers, including less financially literate customers and minorities, are protected. Furthermore, the act reformed numerous government agencies including the Federal Reserve to better manage funds (Amadeo, 2018b).
The Federal Reserve and Treasury engaged in stabilizing the economic environment by lowering interest rates, providing sources of liquidity, and focusing on reviving financial markets and investor confidence. Monetary policy was on the primary agenda by easing interest rate instruments and credit conditions to relieve upward pressure from the banks. More valuable terms and longer maturities were offered by the Federal Reserve to maintain the liquidity of the economy.
Other federal policies have focused on fiscal stimulus on the economy, bypassing the troubled financial sector. Regular consumers were aided with foreclosure mitigation to prevent people from losing homes and reducing downward pressure on house prices (Kohn, 2009). Overall, a large focus of government policy at the time was focused on long-term future growth and stability by addressing vital issues of the financial industry.
The Dodd-Frank Act essentially implemented rigid controls of the system that would prevent abuse and mismanagement. Furthermore, it focused on providing transparency and bringing to light numerous hidden financial practices such as hedge funds and securities exchanges that have previously been largely unregulated. It now prevents the manipulation of the financial system and instruments for the profit of a few individuals and organizations. Also, it curbs inflation of financial figures in a manner that deceives investors and government regulators. Finally, it introduced much-needed standards to the financial system.
The reforms to the credit system ensured consumer protection that banks previously abused through hidden manipulations or using terms of services that were inherently high-risk for individuals with mortgages. As a result of this legislation, critical indicators of financial stability and confidence improved, including asset quality, liquidity, and capital strength. (Amadeo, 2018b). The Act achieved its primary purpose of tightening regulatory control of the industry.
The extensive and deeply recessive nature of the 2008 financial crisis led lawmakers to consider various policies to focus on the issues which served as causative factors. As described, legislations targeted banks and financial operations, but policies also had profound impacts on the overall system. New regulatory bodies emerged, not only in the United States but globally. This allows for extensive oversight and accountability from financial organizations, many of which conduct business internationally.
The recession and following investigations revealed a toxic, corrupt, and predatory corporate culture in banks, which approved and promoted engaging in various dangerous economic practices. One of the effects of legislation and the formation of regulatory agencies has led to the elimination and strict control over corporate culture, including executive payouts (Marria, 2018).
Finally, fund management was addressed through policy. Banks are now forced to protect funds necessary to pay off their customer’s savings and loans. The bail-in method also became popularized, as a financial organization must rely on internal funds and reform to stabilize its operations, rather than depending on government and taxpayer bailouts. Furthermore, these funds cannot be used for investment purposes to ensure the protection of customer assets in case of bankruptcy (Marria, 2018). Overall, significant progress has been made due to fiscal policy, causing reforms in the banking industry and increasing oversight.
It is evident that the 2008 financial crisis was complex, caused by deregulation and abuse of mortgage-backed securities and derivative investment. It resulted in significant macroeconomic impacts at the international level. Financial regulations, such as the Dodd-Frank Act implemented in the years after the recession have specifically targeted predatory practices and have encouraged transparency in the financial markets. The legislation has been effective in reducing any unstable measures and has led to a prospering economy. Going forward, as the Trump administration continues to repeal many of the post-crisis regulations, it is important to examine their importance in addressing the vital economic management that led to the Great Recession.
Amadeo, K. (2018a). Causes of the 2008 global financial crisis. The Balance. Web.
Amadeo, K. (2018b). Dodd-Frank Wall Street Reform Act. The Balance. Web.
History.com. (2018). Dodd-Frank Act. Web.
Kohn, D. L. (2009). Policies to bring us out of the financial crisis and recession. Web.
Marria, V. (2015). 10 years since the 2008 financial crisis: How have the rules changed? Forbes. Web.
Michael, N. (2015). Government policies caused the financial crisis and made the recession worse. Forbes. Web.