Financial Crisis of 2007-2008

Zach Persky

Dr. Kypraios

Monetary Econ

The Financial Crisis of the Mid 2000s

In the Mid 2000s the United States experienced a severe financial crisis that severely disrupted the financial market. Many economists consider the crisis the worst since the Great Depression of the 1930s. Over the course of history in the United States, there have been several financial crises and various steps have outlined the ways in which these crises are ignited. The first stage is the initiation of the financial crisis. Once a crisis has been initiated, a second stage of a banking crisis ensues. The third stage of a financial crisis is debt deflation. In the crisis that began in 2007, major problems of asymmetrical information in the residential mortgage markets led to the national epidemic that is now referred to as the Great Recession.

A key cause in the initiation of a financial crisis is the mismanagement of financial innovation. In the 2007 crisis, there was financial innovation in the mortgage market. Advances of computer technology and new statistical techniques in the early 2000s made residential mortgages available to borrowers with marginal credit records. Prior to the 2000s, only the most credit worthy borrowers could obtain these mortgages. These borrowers were known as prime borrowers (Mishkin, 192). Credit risk became quantitatively analyzed by what is known as a FICO score, which predicts how likely a borrower is to default on their loan payments. Because advances in computer technology lowered transaction costs, banks were able to offer subprime mortgages to borrowers with poorer credit records. These mortgages were financed through securitization. This is the process of various types of contractual debt, for example residential mortgages in the case of the 2007 crisis, and selling the consolidated debt as bonds to investors. These securities are known as mortgage backed securities (Mishkin, 192). However, because of the fashion in which...