Question

Explain how/why the 2008 financial crisis happened and how the US federal government contained that crisis.

Answer 1

The reasons for recession 2007-2008 were
1. Creation of housing bubble: Banks had provided large amount of housing loans assuming that the house can be used as mortgage. At that time prices of houses were artificially very high creating a housing bubble. When the bubble burst prices of house nosedived creating a crisis when customers of banks defaulted their payments. This kick started the recession.
2. Loans to subp rime borrower: Loans were provided even to less credit worthy customers . This increased the chance of default and loans given to such customers became toxic assets.
3. CDS (Credit Default Swap) : The credit risk of investment banks were insured by third party. When default increased the bad debt of investment banks could not be covered by insurance companies as the default was so huge that insurance companies could not cover the losses. Lehmann Brothers was the biggest casualty of CDS.

The US federal government contained the crisis by following ways:
1. It started bailing out too big to fall companies like AIG(which is the largest insurance company). It also nationalized Fannie and Freddie which were the federal mortgage insurers.
2. It started quantitative easing in which the Fed would purchase securities and increase the liquidity in the economy.
3. It increased lending to automobile industries to bail out many companies who were under heavy debt burden.