Nina Chen
TA Kelsey
Section 16
12/9/18
FROM EVERYTHING TO NOTHING: THE 2008 FORECLOSURE CRISIS AND ITS EFFECTS
Blog
What Caused the Crisis?
The Financial Crisis of 2008 occurred mainly because of deregulation. Deregulation is when the government removes or reduces restrictions made on industries in order to improve their business. This allows banks to engage in hedge fund trading with derivatives, which means that privately-owned companies could reinvest their money into financial instruments through a financial contract that obtains its value from an underlying asset. Derivatives are often used for commodities like oil and gasoline; but in this case, derivatives are based on stocks or bonds and use interest rates in the financial system. Derivatives are easier to trade than the asset itself because the seller does not have to own the asset. The seller can give the buyer money to buy the asset at its prevailing price or create another derivative contract to offset the value of the first. The ultimate goal of these firms is to outperform the market.
But, because of these trades, banks began to demand higher mortgages to support the sale of derivatives. Interests rates on new mortgages were reset and homeowners who could not afford to pay it off had no choice but to take out loans because they could not sell their house. When the derivatives’ values went down, banks stopped lending to each other, which caused the Financial Crisis of 2008 and the start of the Great Recession.
Subprime Loans and its Effects on Homeowners
One method of loans that banks are fond of using are subprime loans. Subprime loans are primarily loans for people who cannot maintain their repayment schedule, often reflecting setbacks like unemployment. Usually, subprime loans are only offered to people that have less than perfect credit, but banks would be willing to loan to someone with less than “prime” qualifications with a higher interest rate. The higher interest rate for lenders is intended to compensate the lender for accepting the greater risk in lending to borrowers who cannot pay back their loan. The interest rate usually covers any losses they might occur. Many banks realized how much profit can be generated from subprime loans and began selling them in bundles in the form of stocks and selling them to investors across the globe. The demand for these derivative stocks increased and banks began to give this loans to more borrowers. As the supply of derivative stocks began to decrease, banks targeted those who were excluded from homeownership.
I recently met a young girl whose family was affected by the Financial Crisis of 2008. Kady mentioned that ever since she was a little girl, her parents were set on buying a house of their own and that being able to own a home is a great achievement. Growing up, She felt secure with her family in their home and being surrounded by material items gained from hard work. She told me how her parents lost their jobs in the recession and were unable to produce the money to pay off their loans. Most subprime loans have a two-year adjustable interest rate, also known as teaser rates. It allows borrowers to agree to a lower interest rate for two years, but after that, the interest rate would return back to the normal market index. This could mean paying almost triple the amount per month. Kady’s parents most likely took out a subprime loan and could not come up with such a large sum of money every month because of the high interest rates.. They tried their best to come up with the necessary funds, even selling all their material possessions in order to pay off some of the loan, but it still wasn’t enough. Under the financial pressure, Kady’s parents later turned to drug abuse as a result of depression and stress.
Kady eventually entered the foster care system and began living from place to place. She realized how sheltered she had been under her parents’ financial security. When that all fell apart, Kady had to learn to endure many hardships on her own, which influenced her mentality to remain hopeful to find a permanent home. She is now a sophomore in college and hopes to become a healthcare administrator in order to help make healthcare more accessible for those in need.
This shows how the financial industry is fueled by greed for money. Many big banks loan money with high interest rates so that they could maximize their profits for the borrowers. This method of banking does not only help banks and firms make large sums of money of the American people, it is unfair. However, there are alternative methods of banking that are less conventional.
An Alternative Banking Method: Islamic Banking
The conventional banking system is based on paying interest at a predetermined rate for certain deposits of money. However, Islamic banking is a different financial system. Because payment and receipt of interest is prohibited by the Shariah law, the idea of interest may seem unfamiliar and strange to those who do not use this method of finance.. Muslims turn to Islamic Banking, also known as “interest-free banking”. Islamic banking does not support usury, speculation and gambling because investments that support industries that cause harm to the people and society are forbidden. Derivatives are seen as dangerous and risky because it is contingent upon unknown future events.
Differences Between Conventional Banking and Islamic Banking
One important aspect that should be considered into how different societies choose different banking methods is their culture. This goes to show the negative effects of conventional banking because it is a banking system based on man-made laws. It is profit-oriented and its main purpose is to make money through interest. Because of our capitalist economic system, the overall goal for most businesses and firms is to generate as much profit as possible. In this case, the banks prey on those who cannot afford homes in order to maximize their revenue and outperform its competition instead of finding a method where everyone benefits.
On the other hand, Islamic banking promotes the principle of financial justice. Because islamic banking looks down on usury and speculation, Islamic finance companies main objectives are profit creation and growth. They choose to invest based on their potential for success, which is a contrast against conventional banking, which focuses mainly on maximizing profits. Also, economic exchange in Islam is directly tied to Islamic values. Islamic economics ties in both religion and economics, which westernized banking does not. For example, ‘riba’, is a Qur’anic term which its interpretation depends on the practice of the community. This means that there is no clear definition of how finance should be handled; it depends on the circumstances.
I believe that Islamic banking is a good alternative to the traditional method of banking.The conventional banking system is not beneficial to all of society because many people suffer from the actions of big businesses. Islamic banking is more efficient and beneficial to society because there is a balance between the wants and needs of businesses and the people; loss is shared when the organization suffers lose, while in a conventional banking system , interest is charged, even in case the firm suffers losses because there is no concept of sharing loss. In Kady’s situation, islamic bankers would look down on the methods bank use to increase its advantages in the market. For example, the use of subprime loans and interest would be heavily looked down upon because it takes advantage of the borrowers. If we were to change the conventional methods of financing into something more efficient and beneficial to all of society, the overall wealth of the community would increase and everyone would be able to live without the fear of being financially insecure.