How Overvaluing Assets Causes Financial Crisis

Overvaluing Assets Is The Most Harmful Cause Of Financial Crisis

There are a number of causes behind financial crisis, and arguably the worst is the overvaluing of assets.


Hundreds of years ago, financial crises were insulated. It was a problem that a country would face on its own. If one country plummeted, others would face little to no struggles in relation.

Today's economy has been globalized. Investment banks are global. Oil companies are global. Free trade is encouraged, and the exchange of goods and prices have high interconnectivity. As a result, a financial crisis in either the United States, China, or the United Kingdom can have a rippling effect on the rest of the world.

There are a variety of things that can cause a financial crisis. One of the most harmful is the overvaluing of assets. Overvaluing assets caused both The Great Depression and the 2008 Financial Crisis. What is overvaluing assets, and how does it really harm the economy?

The overvaluing of assets typically originates in the stock market. That's how it started both in 2008 and 1929. To better understand overvaluing assets, we can study the 2008 financial crisis.

Banks were engaging in risky lending practices in 2008 like sub-prime loans and mortgage-backed securities.

Subprime Lending: Typically banks don't lend to individuals with low credit or little collateral. In the '90s however, banks began to engage in this sort of lending. This made it easier for people, in general terms, to purchase homes. As a result, the demand for homes rose quickly.

Mortgage-backed Securities: Banks also started to trade mortgage-backed securities. These were essentially bundles of a hundred mortgages, packed together. These securities were categorized by risk and being sold and bought by different banks. But banks knew little to nothing about the ability of these borrowers to pay back their mortgages. Despite that, the securities were being traded.

Eventually, low credit borrowers began to default on the loans. The sub-prime loan business began to tank, recouping little to nothing on their loans. Even further, the mortgage-backed securities were valued significantly higher than what they were worth.

A simple example follows. Banks had originally believed they may get 70% of the borrowed money back. They reported such numbers as assets in their books. But since they didn't really know much about the mortgage-backed security they purchased, they were surprised to find out high rates of borrowers were defaulting. They were making pennies on the dollar. The public began to notice and as a result, lowered stock investments into these banks. The stock market began to decline, and financial institutions were losing tons of money.

In situations where banks are closing and need money, there are two options:

1) get a loan from another bank, or

2) get a loan from the Federal Reserve.

But banks were afraid to make loans to each other because they didn't know the real value of the banks who were borrowing. Would they be paid back or not? So loans from banks to save other banks declined. Interbank lending dried up.

This led to a credit crunch. Banks were afraid to loan to everyone. If you weren't a top of the shelf creditor, you weren't getting a loan from the banks in 2008. Because of this, saving increased and spending declined. Banks weren't making investments in firms or households. Capital decreased dramatically. Without a loan, how can a business buy all the new equipment they need? How can they finance some of their more costly processes? Businesses closed.

In the end, the decrease in capital led to lower levels of productivity, creating a vicious cycle of crisis.

There are a few things that can be done to fix it. In this situation, the Federal Reserve did its best to preserve financial institutions. They "bailed out" the banks. The economy took years to recover, even after the necessary measures were taken. This sort of financial crisis can be dangerous for an inept economy. But at times it can be difficult to avoid such situations. There is little that can be done to anticipate this sort of situation. Questionable bank practices are difficult to monitor, let alone their impact on the economy.

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The Financial Crisis Of The 2000s

The financial crisis that affected everyone.

The global financial crisis that took place in 2008, following years of corruption, cost 20 trillion dollars and affected the whole world in a negative way except for a select few. These mischievous individuals were the ones that cost the people of the world their jobs, homes, and wellbeing.

Greed which stemmed from deregulation, was an overarching problem. From 1940 to 1980 the financial industry was regulated. In 1981, Reagan's secretary, who was the CEO of Merrill Lynch, started a 30 year financial deregulation. By the late 1990s, the financial sector was dominated by only a few companies: Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch, Bear Stearns, Citigroup, JPMorgan Chase, AIG, MBIA, AMBAC, Moody’s, Standard & Poors and Fitch. If they failed, everyone would be affected.

Years before the inevitable Great Catastrophe, people, who wanted to take out a mortgage, would be thoroughly analyzed by the bank. It was vital for the bank to get its money back as well as interest. Then everything suddenly changed. Everyone was being given a loan without question. It did not matter if they were employed or not or if they were going to pay it back. The burden no longer rested on the bank. Instead of selling to local investors, the bank sold the unpaid notes to investment banks which sold them to investors with the help of a bribed rating agency. These mortgages or other loans were called CDOs: collateralized debt obligations. CDOs were also referred to as derivatives. Even the riskiest subprime loans were given AAA ratings which resulted in many people not repaying them. This was detrimental for the investors.

The credit default swaps, CDS, were similar to a sort of insurance. They were used to bet against CDOs. If a CDO went bad, they would pay for the losses. Goldman-Sachs was aware of everything it was doing but with CEO Henry Paulson, it sold more than 3 billion dollars of CDOs. These were still given a AAA rating since the rating agencies was accepting bribes. The more money the customers lost the more money they made.

Individuals like Henry Paulson were stealing and ruining the economy in a worst way and no one was doing anything about it. The few that wanted the financial sector to be regulated were unsuccessful. The derivatives made the markets unstable and even Warren Buffett called them “weapons of mass destruction”. It was as if the bankers could gamble on anything. Congress banned the regulation of derivatives. Even president Obama would voice his opposition to the way the financial sector worked but during his presidency he would appoint the same people who worked for these massive companies to save the American economy.

The prices for houses in 2001-2007 had increased dramatically. As people on Wall Street, such as employees of Goldman-Sachs and Merrill Lynch, were getting huge cash bonuses they were aware of what was about to happen. The ultimate crisis began in the November of 2007. Bear Stearns collapsed in the March of 2008. The government now had to do something since the world’s economy depended on these firms. Fannie Mae and Freddie Mac were taken over by the government and bailed out by the tax players. Lehman Brothers was taken over as well and Merrill Lynch was bought by Bank of America. The commercial paper market catastrophe was decided by non other than Henry Paulson and Timothy Geithner.

Large amounts of people were losing their houses and foreclosures ran high in numbers. The poorest people payed the most. At the same time, the men who decimated the banks walked away with large sums of money. No one was given jail time. No one received any charges. No one was held accountable. The American government even kept and appointed executives from these companies year after year.

There was nothing ethical about the entire situation. The greedy CEOs and executives ruined the economy and people's lives. It astounds me that after all the scandals, the American government still appointed these executives to direct the country's financial sector. Regulation is key. The government must hire workers who are truly not in it for the profit to oversee these large firms.They must learn from their past mistakes. Hiring the same people who have to same agendas is not going to produce different results.

Cover Image Credit: Flickr

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