Causes of the Recent Financial Crisis

The origin of the current financial crisis though attributed to the mortgage market revealed far more loopholes in corporate governance and regulatory framework (Kirkpatrick 2009; Weiss & Larson 2008; Larson 2007). Out of anticipations of massive capital gains the prices of houses in the U.S kept rising which were furthered by government policies that favored private home ownership such as low interest rates (Larson 2007; Rötheli 2010). With such motivations to lending financers instituted new ways of doing business targeting the “sub-prime market” created by the housing demand with risk appraisals being recklessly conducted (Rötheli 2010). Despite there being regulatory bodies that were intended to safeguard against imprudent practices in the financial institutions; the reported accounts detailing a highly favorable performance prevented such imprudence being unearthed (Drawbaugh 2010).

At the basis of the increased lending practices were government policies that intended to shield the economy against the possible effects of busting of the internet bubble and the terror attacks (Larson 2007; Rötheli 2010). Following these events the Federal Reserve had dropped the federal funds rate by a 5 percentage point in two years from January 2001 which served its initial intentions – of providing a buffer to the economy – well but its prolonged application brought along adverse results (Larson 2007, p. 18). The first among these was reducing inflation rates to all time low thus wiping out the value of savings instruments such as treasuries and deposit certificates (Larson 2007). The lower federal fund rates also drove down the cost of borrowing that encouraged borrowing for long-term purposes with rates such as those for mortgage plummeting to very low levels (Larson 2007). A second factor attributed to lower interest rates in the US is the increasing trade imbalances as compared to other countries such as China with related capital flows (Kenc & Dibooglu 2010).The effect of increased motivation for borrowing was to alter the usual equilibrium between saving and risk taking behavior with speculation favoring the latter (Larson 2007). Eventually as the increase in house prices in the US began to fall, financing institutions reset their interest rates that affected the ability of the individuals to service the loans; resulting in high default rates that spelled huge losses for the lenders and ultimate collapse for some (Kirkpatrick 2009).

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