Causes of US Financial Crisis

This essay comprehensively examines the factors contributing to the 2008 US financial crisis, which triggered a global recession. It analyzes the interplay of loose monetary policy leading to increased money supply and a housing boom fueled by readily available subprime mortgages. The essay details how the housing bubble burst, resulting in widespread credit defaults and the collapse of major financial institutions like Lehman Brothers. The role of government regulation, or lack thereof, in exacerbating the crisis is also discussed. Furthermore, the impact of China's role as a major creditor to the US and the subsequent dumping of US Treasuries are explored. The essay concludes by summarizing the cascading effects of the crisis, including decreased investor confidence, reduced economic activity, and a significant rise in unemployment.

Running Head: Causes of US Financial Crisis
Factors that Caused the US Financial Crisis of 2008-09
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Causes of US Financial Crisis 2
Executive Summary
There was a great global recession whose origination was from the USA financial crisis.
There are several factors that are behind the origination of this financial crisis; most of these
factors are interrelated. For instance if we consider the accelerated money growth and the
housing bubble and the credit defaults we can clearly see the interrelationship. The financial
crisis originated from the accelerated growth of money supply as a way of government’s attempt
to improve the economic performance. The government’s regulations were thus the major factors
that influenced the causes of the financial crisis that ended up in causing the global recession.
The growth of money supply stimulated the aggregate demand which raised the demand for
assets. One of the most important asset that people bought was homes; the increased demand for
homes raised their value and prices went up. Many investors found it very profitable to invest in
the construction of new homes to meet the rising demand; a housing boom was created. The
ability of households and investors to raise the housing demand was because it was easy to
obtain capital; this created a housing market boom. This boom together with some other factors
was the real origination of the financial crisis; it was followed by a hurting burst. The burst
lowered the ability of the previous borrower to repay their mortgage loans and thus the financial
lenders were suppressed. Great losses were made, some lenders became bankrupt, the lenders
restricted their lending and acquisition of capital was tightened. Investors who needed capital to
make investments could not obtain it and thus growth of the economy was limited. This is the
financial strain that was felt both in the US and other nations. The stock markets fell due to
uncertainty of further financial drain.

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Factors that Caused the US Financial Crisis of 2008-09
Introduction
Economies perform differently during various business cycles; there are two cycles; the
boom (peak) period where there is an accelerated growth in the economy and the burst
(recession) period where there is strained economic growth. Before 2008, the performance of the
US was high. Pettinger (2017) pointed out that the US economy was stable from 2000 to 2007
with a strong growth, falling unemployment and low inflation. However, despite this economic
stability Pettinger noted that there were rising concerns on the growing instability on the
financial market and credit. There was a boom in the housing industry that resulted in an
increment in the aggregate consumption component of GDP. Thus the GDP recorded before the
crisis was high. This paper will analyze the changes in GDP before, during and after the crisis.
During the crisis, many macroeconomic indicators performance was poor; these indicators
include real GDP, Inflation, Unemployment, etc.
The paper will consider the actual causes of the crisis which resulted from the money
supply growth. It will cover the origination of the money supply growth. This research will show
that the financial crisis in the US was as a result of failure on the financial lenders and the
government. Rosner (2013) pointed out that the government’s regulation on lending institutions
was weak. It shall analyze how each of these parties failed and the impact of each of their
failures. The impacts of the financial crisis were not only felt in the USA economy but was
spread to other nations; there are just a few economies that wasn’t impacted by this crisis. Some
of them that are financially stable were able to implement policies that led to a quick recovery
while others are constrained up to date.
The Factors Responsible for the Financial Crisis
Loose Monetary Policy and Money Growth
In the early 2000s the US economic growth was lower which stimulated the US Central
Bank to lower its interest rates. Malinen (2017) argued that prior to the crisis, the US monetary
policy was loose. The impact of a lower interest rate is an increased money supply since people
are attracted to loans advanced by financial institutions owing to the low cost of repayment.
There was thus an increased borrowing of loans and a greater growth of the money supply in the
circulation. Since investors are always uncertain about the future, they decided to utilize this
available capital to invest in assets that would give them returns in the future. The major asset

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that demand went up was that of the housing industry. Households and investors decided to
utilize this availability of cheap capital to buy homes.
Fig: Growth of money supply
Source: Positivemoney.org (2017)
The graph shows that there was a huge money creation by the banks prior to the crisis.
According to Positivemoney.org (2017), money is created every time a loan is made by the
banks; the money and debt amount in the US economy had doubled in a period of seven year
from the advancement of the loans.
Subprime Mortgage
An increased demand for homes raised the demand for mortgages. Initially, financial
lenders could only advance loans to prime lenders who had good credit ratings and avoided
loaning the subprime borrowers. This is what had kept the housing market in a stable state. The
increased demand for mortgages resulted in the financial lenders weakening their lending

Causes of US Financial Crisis 5
standards. In the period before the crisis, banks were more aggressive and their willingness to
lend to the risky borrowers had gone up (Nitta, 2013). They figured out a way to make the funds
available to the low-income groups through pooling. This strategy was considered less risky but
no analysis was done or had been done earlier to confirm its viability. The proposal was accepted
and the financial lenders started lending to the low income groups without necessarily requesting
them to provide some security. Many subprime borrowers went for the loans and there was a
greater supply of money to many people in this economy. The loans were advanced as mortgage
home loans meant for assisting the investors and households to acquire homes and repay as they
used to houses. These subprime borrowers were risky since their income level was insufficient to
service the loans; the banks failed to do a sufficient check on the ability of these borrowers to
repay their loans; they recklessly gave them huge loans. The government had also set a
regulation towards achieving the goal of non-discrimination on the acquisition of capital because
of the brackets of income. After the credit crunch, these borrowers were left with huge unpayable
loan amounts.
Housing Bubble
The Mortgage loans advanced to the subprime borrowers enabled them to buy homes and
other houses used for businesses. The mortgage loans were given at a very low interest rate and
thus attracted many borrowers. Pettinger (2017) noted that the high confidence for the borrowers
and a growth in bank lending facilitated the housing boom. The access of these loans by the
subprime borrowers caused the homes demand to shoot upward (Muddywatermacro.wustl.edu,
n.d.). The law of demand accounts for a price rise whenever demand rises. The price rise
generated great profits to the investors; more homes were constructed in order to raise more
profit. Many people shifted their investment to the housing market so get a share of the rising
profit.

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Fig: Uses of money created by banks prior to the crisis
Source: Positivemoney.org (2017)
The greatest proportion of the huge amounts of money the banks created were used for
mortgages and secured loans (Mee, 2012); this was equivalent to 31% of the total money created.
The 31% went to residential property and there was a further 20% that went to commercial real
estate.
Credit Defaults
Prior to the crisis, the personal debt in the US was very high. It even exceeded the income
amount and thus at some point became difficult for the borrowers. The borrowers had to repay
their loans with some stated interest rate. After the housing bubble burst, the financial lenders
went into huge losses because borrowers were not able to service their loans further. The
subprime borrowers couldn’t repay their loans; in addition, the prime borrowers could also not
be able to repay their loans. There was a great challenge for the financial lenders. What caused
the global recession is that when people started defaulting on their loans, financial institutions
such as banks tightened their lending behaviors; the money supply was reduced resulting in a

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lowered demand for homes and subsequently a fall in price. The demand law also account for a
price decline on instances where demand is insufficient. The falling prices accounted for the
bursting of the housing boom. The previous borrowers could keep toping up their loans to enable
them to service the loans. The slowdown of lending made it difficult to access loans owing to the
panic caused to the lending institutions. This forced these borrowers to decide selling their assets
and repaying the loans. However, the assets value had declined compared to when the loans were
advanced and thus insufficient money were raised from such sales and the full amount of the
loans was unpayable given the income constraints. Further, the increased default rates caused the
banks to continue tightening their lending such that investments were completely not possible.
Investors’ confidence had also declined and thus economic activities fell significantly; the US
fell into a recession.
Lehman Brothers
Lehman was a giant investment bank and the 4th largest in the US. In 2003 and 2004
when the housing boom was showing up, this investment bank acquired 5 mortgage lenders.
Lehman was accused of creating mortgage backed securities that were toxic and their sales put
the financial market at risk (Williams, 2010). According to Alex (2017), this bank filed for
bankruptcy in September 15th 2008; it was one of the largest victim of the subprime mortgages
and thus argued to have been the major cause of the financial crisis (Cnbc.com, 2010). Its
contribution to erosion of market capitalization was close to $ 10 trillion in October 2008.
According to Mcdonald (2016), it is the collapse of this investment bank that triggered the global
recession.
Stock Market Crisis
The US stock markets are strongly correlated with other universal related stocks;
whenever it is declining, all other stocks declines. After the end of the 2000-02 stock market
crush that resulted from the internet boom, the M&A was plunged by lenders one again (Nations,
2017). The 2000-02 was the 5th wave of stock market crush whereas the 2004-07 was the 6th
wave. The percentage of cash deals rose with this wave and the role played by the LBOs was
larger than with the initial waves (Hooke, 2015). The stock market crash caused the deal volume
to fall by 60% during the 2007/2008 global financial crisis. According to Amadeo, (2017), a loss
in investors’ confidence is responsible for causing a recession.

Causes of US Financial Crisis 8
Dumping of China Treasuries
Mees (2012) argued that the American spending binge was prospered by China and not
by the US. The US saving rate was around 15% from 2000 to 2006 whereas that for China rose
from 38 to 54% during this period. The Chinese are risk-averse and thus their savings are ties to
risk-free assets. The savings buildup in China and emerging economies had expanded and caused
a depression of interest rate in the whole world from 2004; the US Treasury bonds price rose as
there was too much money chasing. Subsequently there was a fall in the interest rate. China and
Japan have been the greatest creditors for the US.
Fig: US treasuries foreign ownership
Source: Gantz (2017)
There was a decline in the US treasuries foreign ownership in 2008 which means that there was a
reduction of the available credit; this contributed to the financial difficulties.
Conclusion
The US global recession was caused by the credit crunch; there was a shortage of
liquidity for the banks and thus a reduced funding. The financial instability lowered business’s
and consumers’ confidence. There was a negative wealth effect as the house prices fell after the
boom. Since the economies are interrelated, the impacts of the US financial crisis were also
spread to other economies and this deteriorated the trade system; there was a decline in exports
as other economies also felt the financial constraints. There was a significant fall in GDP and the
unemployment rate rose. There was a failure of the banks in that they recklessly advanced loans

Causes of US Financial Crisis 9
to the risky borrowers without a sufficient cross-check of their ability to repay. The government
failure is argued in terms of low regulation on the lending behavior by the financial institutions.
The central bank regulates the circulation of money and it could have ensured that the financial
institutions did not cause such a big growth in the money supply. Otherwise it can be concluded
that the government was more impressed with the growth of the economy that was accelerated
by the rising house demand that it failed to look into the impacts that this would have on its
future.

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