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Financial Crisis

26 April 2011

Debate will likely persist for decades over what forces combined in 2007 to trigger the financial crisis that led to the worst U.S. recession since the Great Depression. In earlier periods of economic turmoil, the economy bounced back after the Federal Reserve moved vigorously to lower interest rates. But record low interest rates in 2008–2010 failed to spark the bank lending required to get the economy expanding again. One difference between the most recent recession and earlier recessions is the level of consumer, corporate and government debt.

Many Americans took on significant amounts of debt to purchase homes during a period when real estate prices increased dramatically. When housing prices plunged and borrowers stopped paying loans, the bubble burst, shocking the entire financial system. High-risk mortgage-backed securities were at the heart of the crisis.

In 2010 Congress passed and President Obama signed legislation called the Dodd-Frank Act. The law is designed to:

• Prevent banks and other financial firms from becoming “too big to fail” thus requiring a government bailout.

• Give regulators authority to take over and shut down troubled financial firms in an orderly way before they threaten economic stability.

• Prohibit banks from engaging in speculative investments on their own — that is, not based on demand from a customer.

• Identify and address risks posed by complex financial products and practices before they threaten economic stability.

• Give the Federal Reserve authority to regulate nonbank businesses such as insurance companies and investment firms that predominantly engage in financial activities.

• Regulate such potentially risky practices as over-the-counter derivatives, mortgage-backed securities and hedge funds.

• Protect consumers from hidden fees and deceptive practices in mortgages, credit cards and other financial products.

• Protect investors through tougher regulation of credit rating agencies.

(This is a product of the Bureau of International Information Programs, U.S. Department of State. Web site: http://iipdigital.usembassy.gov/iipdigital-en/index.html)