Stimulate consumer spending and business investment

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Reference no: EM131051369

THE FINANCIAL CRISIS

Looking back a few years ago in 2011, millions had lost homes, businesses had failed, foreclosures were at an all-time record high, and unemployment remained very high at 9 percent. These outcomes were due, in large part, to the financial crisis of 2006-2010. In the year 2000, the tech stock bubble burst, which sent markets plummeting around the globe. Around the same time, ethics violations surfaced for major companies including Enron, WorldCom, Global Crossing, and Tyco. With the economy in a slump, the government wanted to stimulate consumer spending and business investment.

To do this, the Federal Reserve lowered the prime interest rate from 6.5 percent to 1 percent. This ease of credit made mortgages, credit cards, and other consumer loans easy to get. In fact, the average household debt to disposable income in 2007 was 127 percent. The U.S. Congress, through the 2010 financial crisis investigating committee, determined that the crisis was avoidable. Some of the factors identified as leading to the crisis included the proliferation of subprime mortgages that, in the period between 2004 and 2006, comprised about 20 percent of all mortgages.

This was a twofold increase in subprime loans. The SEC lowered the leverage requirements for investment banks, leading banks to borrow significantly more than they had in reserves. During this period of time, mortgage-backed securities (MBSs) were bundled and sold to investors. These MBS products included subprime mortgages, as well. During this same period of time, the major financial rating agencies such as Moody's and Standard and Poor's continued to provide AAA ratings (the highest rating) for MBS products, assuring investors of their value.

In 2007, the housing bubble burst, with housing prices tumbling and the value of MBS products falling, in some cases, to worthless status. Many people found themselves "underwater," meaning that they owed more on their houses than they were worth. These folks and many who had subprime mortgages defaulted on their obligations. As the MBS declined in value, investment banks and other financial firms began to fail, as their debt was higher than the value of their assets.

This financial crisis had global consequences. The failure of very large (or "too big to fail") investment banks could not be allowed to stand; thus, the federal government intervened with a $700 billion bailout for banks called the Troubled Asset Relief Program (TARP), designed to bail out troubled banks and prevent further failures. In 2009, the president signed an $800 billion stimulus designed to help stimulate the economy, help businesses borrow and invest, and as a result, create jobs. The global crisis of confidence described in the video represents the largest economic failure since the Great Depression of the 1930s. The longterm effects of the financial crisis are yet to be completely determined.

1. Describe how the Federal Reserve can use its authority to attempt to stimulate the economy.

2. One of the major problems that led to the financial crisis was the housing bubble. What is meant by the "housing bubble"?

3. Name and explain two of the reasons the Congressional committee identified for the recent financial crisis.

Reference no: EM131051369

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