Causes of the 2008 Financial Crisis

Policy Backgrounders | Financial Crisis

No. 181
Wednesday, February 10, 2016
by Dennis McCuistion and David Grantham

Experts point to a variety of issues that likely caused the 2008 financial crisis, such as modern banking practices, unethical behavior or government policy. The available evidence suggests, however, that a convoluted interaction between the public sector and private sector business was the primary culprit.

This relationship created the subprime mortgage crisis, which caused the 2008 meltdown. Why is this crisis any different, though? After all, government action in private finance is not a new phenomenon.

Evolution of the Financial Industry. In response to a shortage of credit available to residents in low-income communities, Congress passed and President Jimmy Carter signed the 1977 Community Reinvestment Act (CRA). The CRA promoted standardized lending practices for borrowers regardless of race, income or location and mandated that federally insured banks not engage in redlining, the refusal to extend credit to people living in particular locations. Government regulators used CRA as its authority to evaluate banks’ lending practices to ensure financial institutions did not deny credit to the areas they serve. The CRA proved to be a precursor for other future government intervention in the housing market.

In the late 1980s and early 1990s, the savings and loans crisis prompted further changes in regulation, government policy and banking procedures. Savings and loans associations (S&Ls), known as thrifts, served as a type of local financial institution specializing in savings deposits and consumer loans. The government also insured these associations to encourage investment and savings among fixed-income families and individuals. However, between rising inflation, government spending, and other economic factors in the 1970s and early 1980s, S&Ls found themselves with increased debt and decreased capital. Despite federal deposit insurance, many associations went under. And government deregulation policies that followed did little to recover investor money from the failed S&Ls. Federal guarantees for these institutions could not overcome the consequences of their collapse.

Meanwhile, the failure of these smaller, government-backed S&Ls precipitated a growth in larger financial institutions. The Gramm–Leach– Bliley Act (GLBA), also known as the Financial Services Modernization Act, passed Congress in November 1999. It legalized mergers between banks, insurance companies and securities firms previously outlawed by the Glass-Steagall Act of 1933. After GLBA, large investment institutions grew into even larger corporate institutions. Several instances of corporate corruption at large, publically-held companies like Enron ‒‒ an American energy and commodities company found to have engaged in systemic accounting fraud in 2001 ‒‒ inspired regulatory action. In response, the federal government passed the Sarbanes-Oxley Act of 2002, which gave the Securities and Exchange Commission (SEC) ‒‒ the chief federal financial regulator ‒‒ new authority to detect and prevent systemic fraud at these massive financial institutions. These government regulatory powers were intended to prevent future fraudulent activity, protect the investor and ultimately promote the market’s financial stability.

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