Question

The US subprime mortgage crisis of 2007-2008 started in early 2007. It later caused a widespread financial crisis in the US and even in many developed countries around the world. These crises were so severe that they in turn caused a slowdown of the economic activity in the US and, actually, in most of the world. In particular, the Great Recession of the US took place (officially) between December 2007 and June 2009. Some central bankers have argued that the main reason behind these recent financial crises is associated with the principal-and-agent problem. In simple words, "bankers" and investors were not doing what they should have been doing: diversifying risk properly, being cautious in their risk-taking behavior, and measuring properly the risk associated with some investments, especially financial derivatives related to mortgage-backed securities and the like. Other economists argue that the 1999 "deregulation" of the US financial system (which allowed investors to pursue simultaneous activities in the banking system, the insurance system, and the securities market, when the three of them in principle face different levels of risk) is a main culprit. And then some other economists simply argue that financial crises occur every now and then and that there is (are) no main responsible(s) for the crises (they argue: "Irrational exuberance", people become too optimistic about the future, happens and who are we to tell people not to be so optimistic?; and "housing bubbles" occur, but they are difficult to identify and/or quantify). Certainly, there are other "theories" about the origin of these crises. Following the last crisis, proposals aimed at improving the stability of the financial system have already been made, including consumer protection (against predatory lending, for instance), executive pay, capital requirements, and the orderly intervention ("shut-down") of financial institutions that create a significant risk for the whole financial system (control the "too-big-to-fail" problem). Answer the following questions: Could have the sub-prime mortgage crisis of 2007-2008 been avoided? Yes? No? Why? EXPLAIN. Use no less than five lines to explain your answer.

Answer 1

ANSWER: The government regulations could have prevented or mitigated the credit crisis of 2008. If the government regulations were in place to the accumulation of subprime mortgages would have been less. The credit score setting, down payment and proof of income requirements that lenders need to adhere to could have prevented the credit crisis of 2008. Regulations would have mitigated or prevented the credit crisis because it would have prevented or limited leveraged financial institutions from taking on high risks.