Question

What are the major root causes of the recent subprime financial crisis? What are the major policy responses to the financial crisis by Federal Reserve, the Treasury, and regulatory agencies ?

Answer 1

Sub Prime crisis surfaced in 2008, it caused massive fall in the value of financial assets. Financial institutions were extending loans to such borrower who were not having good credit history. These were defaulters and when loans were extended to these sub prime borrowers, they defaulted on loans and crisis became huge and massive.

Causes are as follows:

• Loans were given to such borrowers who were not eligible or were carrying history of default.
• Further, most of loans were given for unproductive purposes, thus these loans could not generate sufficient income to fund loan repayments,
• Federal Reserve is also said to have caused crisis by increasing discount rate or adopting costly monetary policy
• Government also deregulated the many sectors and problem became more acute.

Policy action of Federal Reserve:

Federal Reserve adopted cheap monetary policy and increased money supply significantly in economy.

Federal Reserve, through its open market operation purchased toxic securities from open market. it increased money supply and thereby drive down interest rate.

Further, Federal Reserve slashed discount rate and it increased lending capacity of banks.

Other actions by government:

• Further, Government used fiscal policy by increasing expenditure and reducing taxes. Bailout packages by the congress indeed helped to speed up the process of recovery from economic crisis.
• Government offered $ 85 billion loan to the AIG and few other firms were funded who were facing problem of liquidity.

Bankruptcy was prime cause of prolonged crisis, government attempted to address it through the myriads of fiscal and monetary policies.