The global financial crises unraveled in mid-2007 and early 2008 when the subprime mortgage crisis burst the bubble after a great period of economic boom, causing great stress and a complete breakdown of the financial markets in the U.K, U.S of America, and then later on the entire world. It started when the US sub-prime mortgage market collapsed due to the default on payments. a sub-Prime mortgage is a loan made for homes to borrowers who are not eligible for prime home loans because they either do not have a sound credit history or have none at all. For example, people with low incomes, low bank transactions, history of defaults or unemployment, can use these mortgage loans to purchase homes. These loans are generally given out by lenders on higher interest rates, additional fees, penalties for early satisfaction of the loan, and other additional costs such as adjustable interest rates (ARM). With such instruments where the borrowers do not have a credit history for the borrowers to base their decisions on, there is a high risk of default. What was once known as the powerhouse of the economy in 2007, the real estate business took a complete downturn, which was not anticipated as the prices of houses had not declined since World War 2 and were on the rise after the great depression, and thus, lead to the liquidity crunch in the US market. The mortgage that was backed by real estate lost all its value hence defaults on payments occurred.
The demand for houses increased also during 2001 because the federal government reduced the interest rates, it was the lowest in 2001. This allowed people to invest in more houses and people started buying vacation houses and second homes. The builders continued building more and more houses even after the demand for property started to decrease after a while. The property market became so overvalued that finally, the market collapsed, resulting in a rapid decrease in the rates of properties and property demands (University of Iowa, 2008).
The effect of the mortgage crisis was that it also led to the credit crunch in the US and thus throughout the world. It spread throughout the world because the world is now a global village and businesses throughout the world are interconnected. Therefore the companies who invested in such companies were also affected very much. Demand for goods and services declined therefore production declined, profits decline, layoffs occur. It is said that as many as 80 million more people could be forced to live in extreme poverty as a result of the global financial crises. People started losing their jobs and thus unemployment raised. The average incomes of the people are going down; people have reduced their spending especially on luxury items in order to save more because inflation is also hitting the economies. Inflation was due to the rising prices of basic commodities and of oil. For example in the UK, inflation went to its record peak from 2.1% to 5%. Also, interest rates increased during the period due to which it was difficult for people to buy things on a credit card due to higher interest payments. Therefore the demand for products decreased throughout the world and the exports of many countries were affected. Therefore every country is affected in this way. Though the intensity might be different for every country the effect is throughout the world. For example, UAE was also affected but a bit later than other countries because UAE produces a lot of oil, and oil prices were at record peaks of $147 a barrel. But when oil prices went down along with the general prices of the real estate, UAE also came under this cycle. This is how mortgage crises developed and affected the average people and the neighborhoods.
Many Credit Rating agencies also played a major role in the event. The Mortgage backed securities which were in great demand the early 2002, continued with the increasing demand and although the market became extremely saturated, these mortgages were still given out and ratings were given to these MBS’s making them look very safe and sound investment with very high returns, although this was highly overrated and misleading as they were only unsafe mortgage loans.
The liquidity crunch in the Western economies was also affected by the process that was meant to manage risk, that is, Securitization. All the financial assets are hedged by instruments such as derivatives which back the financial asset by a real asset. In actuality, Banks and Financial institutions used these instruments to hedge funds and provide very attractive products to its customers which at first looked quite safe as proper models such as black Scholes models were used to price such options, however, the financial experts went wrong with the miscalculations and did no stop. They became greedy and selfish and started predatory lending which refers to lending to people of old age and low income and people who do not have the right kind of financial information required before investing in financial activities; it was this greediness that got them into trouble unsustainable debts and mortgages were given out and there was no backup plan. The borrowers in the US overestimated their creditworthiness which made it all the more difficult to realize that there was a problem.
Let’s take the example of Lehman Brothers, On September 15, 2008, Lehman Brothers one of the major asset holders in the US, filed for bankruptcy. This was the largest bankruptcy filed in the history of the US with Lehman’s share value after the bankruptcy falling to less than $1 per share. This occurred to the excessive amount of sub-prime mortgage and lower-rate mortgage backed by securitization, given out by the bank, and no way to sustain the number of loans. With the tightness in the credit market increasing, Lehman Brothers started facing problems at the beginning of 2008. By September, Lehman Brothers thought upon the idea of selling its stake to the Bank of America and asking the Government to bail the bank out of this crisis, the Government and the banks such as the Bank of America and Barclays refused to bail them out and they filed for Bankruptcy. The case of Lehman Brothers had a ripple effect on the US economy and the economies outside the Western frontiers.
In my opinion the banking system in the US was not regulated enough to control the situation and to have a check and balance of everything, in fact it I was so deregulated that banks were able to come up with many diversified products and sell whatever they could to the customers, making these products look more attractive and safe. If however there was more regulation towards the sub-prime and low-rate mortgage also in the areas of loan able funds, this problem would not have escalated. Banks came up with new loans such as ARM’s for the new home buyers. Very little risk analysis was done by the banks and the credit rating companies and that too used inefficient models and inaccurate data. In The US of America there is no concept of a central bank which controls or monitors the activities of many major financial institutions such as insurance companies, finance companies and banks. This lack of control makes it difficult for theses institutions to stop. With the market flooding with different instruments and products and the flexibility provided to both the lender and the borrower, no one wants to stop and think about the negative consequences. People in the US invested in these banks because they did not have the knowledge or the right kind of information. Had there been a strict policy of banks ensuring that the customers knew what they were getting into would have made this situation a lot less worse. This kind of regulation was also important during the days of he unraveling as it would have stopped the unethical practices of the banks such as predatory lending. These kinds of unethical activities eventually lead to the worsened economic situation.
Deregulation refers to the relaxation given by the government and the removal of the restrictions that are imposed by the government. These can include taxes, quotas and marginal interest rates, basically on any sort of industry. It gives the industries the benefit to sell, promote and use techniques that suit their pockets. During the period of 1987 to current 2006, The federal government under Chairman Alan Greenspan was in favor of self regulation of the financial markets. This sort of ease and relaxation given to these financial sectors allowed investment banks and commercial banks to come together and provide joint services. More and more diversification of products took place. This allowed the Big names to get away with weak risk assessment of these products. Although this kind of a policy as many would say is desirable for the right kind of growth, mismanagement and lack of control resulted in a great chaos. The policy lead by the chairman was considered so desirable and positive that they ignored the signs that showed that they might get into a lot of trouble.
In my opinion the areas that need to be controlled are the banking sectors of the United States, as they were providing consumers with consolidated products; they would merge two different products into one. This consolidation of different products led to customers believing that these products were a sound investment. It was quite misleading as people trusted the big names and believed that sub prime mortgage and other financial options is the solution to their problem. Here strict action should have been taken to control predatory lending also.
Another area where I think America and UK needs to work on is the kind of industries it has. American is not producing anything. More than half of goods and products that these western nations consume are imported from countries like China and Japan. This was and I a major problem as US. Debt has been continually increasing, bringing them into more serious trouble. If American and the UK do not start producing its own goods it will fall deeper and deeper into the pool of debt. Industries need to be setup. Imports need to be reduced and more over investor trust has to be brought back so that the markets flourish again. Until and unless investor trust is gained back, the US and UK markets will not be able to get back to the top position. For countries in the world, Western markets need to be strong enough.
References
- Acharya, M. (2007) Credit crunch – the big picture, The Star. Web.
- CNBC, (2007) Gloom & Doom Economist: Credit Crunch Will Spread. Web.
- Credit Crunch, (2007) Crunch Time for Credit? An Inquiry into the State of the Credit System in the United States and Great Britain.
- Faber, M. “Gloom & Doom economist: credit crunch will spread.” CNBC. 2008.
- Gieve, J (2008) Speech, John Gieve: the credit crunch and the UK economy. Web.
- HM Government.
- Hodgson, A. (2007) Global credit crunch: turbulences and outlook, Euro monitor international.
- Nazar, Y. (2008) The fall of US financial capitalism, Dawn.
- The Debt Clinic, (2007) All you need to know about the credit crunch.