The Property Bubble That Caused A Financial Meltdown

A lot of people are of the opinion that greed and excessive risk are the cause of the 2007-2008 financial crash. But blaming greed is like blaming gravity for the plane crash, the gravity was always there the issue is probably in the plane itself. Obviously all this didn’t matter to the politicians or mainstream media who were quick to blame the Wall Street for the crash and decided that the banks needed more regulation and more government intervention.

One of the more important cause of the crash was the bursting of the property bubble in the USA. But what caused this bubble? After the .com bubble burst and the attack of 9/11 the Federal Reserve decided to revive the economy by lowering the interest rates from 6.5% to 1% over a period of two years. The government granted special privileges like tax exemptions, favorable regulatory treatment and an unlimited line of credit from the Treasury to a few firms called Government Sponsored Enterprises (GSE).

When a bank loans money to someone it can sell the loan on the secondary market to an institution like our GSEs, this way the bank reclaims its lent capital, frees itself from the risk of loan default and can now loan the money again. In turn these GSEs packaged these loans into securities called mortgage backed securities. Added to this the government also forced the banks to offer loans to low to medium income families and especially to racial minorities in order for everyone to have a home, this ended up giving mortgages to the people that could not afford it before. Since everybody had access to cheap and abundant home loans, this increased the demand of real estate and consequently its price. This caused the people to buy houses not only as residence but also to try and resell them profitably. But eventually the prices peaked and began to fall. Now the loans that seemed cheap turned out to be costly and people found it easier to give up their homes than keep up with the mortgages.

As I mentioned earlier, everybody tends to blame the banks for this and looks at regulation as the solution. But in reality it was government regulation that forced the banks to take risks and this eventually caused the financial meltdown. If the government had not intervened in the otherwise free market, the interest rates would have been decided based on demand and supply and would not have given the wrong indication that houses are cheap, because in the end the entire economy ended up paying for those houses and not just the people that bought them.