The financial crisis that occurred in the year 2008 was, up to date, one of the most crucial and disastrous economic events in modern times, vastly affecting the millions in the world. Unparalleled unemployment caused a severe contraction in the global economy that commanded multi-billion-dollar government bailouts. But it is a thought that begs: could we have avoided this financial crisis? This was the perfect storm created through reckless decisions, misaligned incentives, and ignoring many warning signs. The article shines the light on events, decisions, and failures that predated the financial crisis in a search for individuals and institutions right at the heart of it.

The Housing Bubble: A Time of Unprecedented Growth

In fact, the seeds of the financial crisis were laid many years in advance in the housing market. An unprecedented boom occurred in the U.S. housing market during the early 2000s: the interest rates were low, and the economy looked to be surely on the rise. But following the collapse of the dot-com bubble in 2001, the Federal Reserve had slashed interest rates to near historic lows and, thus, made that trend possible-which put tinder into this demanding fire of housing. The more it rose, the more a good portion of Americans seemed to buy real estate as if it would turn a coin overnight-a kind of self-supporting demand.

While all that went on, mortgage lenders relaxed their conditions. They began giving mortgages to people who otherwise would never have qualified, including people who had poor histories of paying their bills; these came to be called subprime borrowers. This behaviour was also encouraged by a government interested in promoting home ownership as part of the “Ownership Society,” particularly for low income people who did not traditionally have access. Many of these subprime loans were given on variable rates: the borrowers would have the monthly payments balloon after some time.

Less visible to the general public was the way in which investment banks and other financial institutions converted the rapidly rising demand for homes into something far more lucrative but not at all safe: an MBS, a prepackaged package of these toxic mortgages, passed along for trading to investors and often portrayed as virtually safe and sound even when they were heavy with very high contents of subprime loans. The idea was that though many would default, the pool as a whole nonetheless would be profitable. This supposition ignored one important fact: when the overheated housing market began to chill gradually, defaults, in turn, went epidemic, and colossal losses were the result.

The Function of Rating Agencies and Misjudging Risk Measures

One of the prime players in the pre-financial crisis period was the credit rating agencies, a firm like Moody’s Standard & Poor’s, and Fitch were involved. Their job was to ascertain the risk underlying those various types of financial products, including those mortgage debts. Theoretically, it was meant to show an investor where safety lay concerning his or her investment. However, the rating agencies were caught in a precarious situation since strong pressure was also being exerted by the financial institutions who were issuing those securities. Sometimes these agencies granted high-rated ratings to MBS products even though the latter were made of risky subprime loans.

The reasons for this failure are not difficult to find. The institutions that paid the rating agencies were the very institutions whose products were being rated – a clear and very serious conflict of interest. Though the rating agencies rated the financial products, the complexity of those financial products was underrated. They rated mostly based upon historical data. Continuous growth in house prices was assumed. House prices started to drop, and along with them, the real risks of these products began to surface. But by then, it was already too late.

These inflated ratings would deceive investors. They led to a false notion of safety and security upon the purchase of these mortgage-backed securities. Many financial institutions would buy these MBS products, thinking they were making safe investments: all major banks, pension funds, and insurance companies. So, when it really started to go south, its value completely crashed-the bottom fell out in housing-and gave rise to disastrous implications.

Bankers and Investment Firms-A Culture of Gamble

Behind the flying high financial world were the bankers and executives who made the critical decisions that finally created the crisis. In investment banking during the early 2000s, a culture of aggressive risk-taking and obsession with near-term profits had become prevalent. In fact, most of the executives in large investment banks such as Lehman Brothers, Bear Stearns, and Merrill Lynch were big bettors on continued growth in the housing market. Enormous bonuses other than remuneration schemes linked to short-term profits encouraged them to excessive risks.

But in truth, executives at firms like Lehman Brothers were pushing their employees to take ever-riskier gambles in pursuit of fat profits. In the years before the crisis, they had become ever more dependent on debt-sometimes using their own mortgage-backed securities as collateral-to finance their activities. This practice, called “leveraging,” allowed them to magnify their potential profits. But it also magnified their potential losses, leaving them much more vulnerable in case the housing market fell.

The size of the risk taken in the financial sector was gigantic: investment banks not only held an enormous amount of subprime mortgage-backed securities but also developed and sold a lot of derivatives known as collateralized debt obligations, or CDOs. This was supposed to spread the risk, but they actually remained unintelligible for most investors while their true risk mostly remained unknown prior to the beginning of the crisis.

Missing the Omen

With unabated growth in the housing market, several experts and economists started raising the red flag against such high growth rates, which were unsustainable. As early as 2005, economist Robert Shiller famously warned about a housing bubble, citing rapidly rising home prices and speculative behavior in the housing market. Such warnings fell on deaf ears for financial institutions as well as policy makers. What they had in common, if anything, was a near-blind faith that this time it really would be different, that this housing market could only go one way-upward.

It was, with the benefit of hindsight, an unstable system for which there had been some pretty good evidence. One flag was just how much leverage was being taken by the financial institutions themselves. Another red flag was simply how many of the subprime mortgages were given out; a number of those were adjustable-rate loans with very, very low teaser payments that ranked as one of the key bad behaviors at the bottom of the market.

But all this was warnings falling upon deaf ears since many in the financial sector and government downplayed the risks. Entrenched since the 1980s, this ideology of deregulation fostered the idea of self-regulating financial markets. Further, this depth of belief in the efficiency of markets ensured that this lack of oversight underpriced systemic risks of the housing bubble.

Government Policies

In building these preconditions for this crisis, there were some important roles government policies played. In the late 1990s up to the early 2000s, tremendous pressure to expand homeownership among Americans of low-income level was applied. Government-sponsored entities such as Fannie Mae and Freddie Mac were very instrumental in the process of securitization of mortgages, including subprime ones, by guaranteeing those loans and thus making it easy for the banks to sell those instruments to the investors. Government wanted high rates of home ownership, but then came some unforeseen evils.

Policies to boost home ownership rewarded lenders for loosening standards, along with the consequences of a phenomenal increase in subprime lending. It also meant that investors little reason to sweat over just how good their mortgage-backed securities product was since government implicitly had their backs. It was a combination of government policies, which encouraged a housing bubble and also private-section risk-taking, that created a financial crisis in turn.

The Final Collapse: A House of Cards

By the year 2007, the first fissures in the housing market began to appear as home prices, which had risen with implacable steadiness, finally started to fall. Subprime borrowers against whom loans that they could barely afford were thrown started defaulting in droves. As the defaults mounted, so did declines in mortgage-backed securities valuations, with banks and financial institutions posting huge losses.

It was in the year 2008, Lehman Brothers, one of the major investment banks, were forced to file bankruptcy as it could not locate the finance that it had been searching for. Though earlier, the Federal Reserve had saved Bear Stearns from bankruptcy with utmost proficiency this fall of renowned bank sent shock waves through those frail financial markets of the world. Whither the financial institutions went, so followed the crisis in interconnection. The credit markets seized up; banks stopped lending, and the global economy waltzed its merry way into a tailspin.

Could We Have Avoided It?

It is thus fair to say, in reflection, that at any moment in time it was able to prevent the financial crisis. Rather than this, a combination of complacency, greed, and poor policy choices placed each in a position where the known risks were either ignored or poorly understood. Tighter lending standards and greater supervision of the mortgage market may have heading off the bursting of the housing bubble. Financial institutions could have done much better in disclosing the risks associated with mortgage-backed securities and collateralized debt obligations. The rating agencies could give much more realistic ratings about the risk involved. Of course, most importantly, the government’s policy might have been framed in a manner to better ensure that the pursuit of the benefits of home ownership would not be at the cost of financial stability.

This means that, in the case of a financial crisis, many actors did not recognize the dangers beneath a prospering economy. Can another financial crisis be avoided? Possibly, but that would require much more pro-activity on the side of risk management and regulation, and also some readiness to oppose assumptions dominating the view and assuming that nothing really terrible happens within the housing market. That never happened, and the whole world paid the bill.