| The Financial Crisis and a Fragile Global Economy |
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| Written by Leroy Almendarez |
| Thursday, 02 July 2009 13:15 |
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It may not be clear whether we stand at the start of a long fiscal crisis or one that will pass relatively quickly. The full extent will only become obvious in the years to come. If the goal is to avoid future deep meltdowns of this or even greater magnitude, the root causes must be addressed. Before the causes are addressed, it is almost imperative that some historical perspective be visited. The immediate cause or trigger of the crisis may be attributed to the bursting of the United States (U.S) housing bubble, which peaked in 2005-2006. High default rates on subprime and adjustable rate mortgages (ARM) began to increase quickly thereafter. An increase in loan incentives such as easy initial terms and a long term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief that they would be able to quickly refinance at more favourable terms. In the early 2000s, mortgage interest rates were low, which allowed borrowers more money at a lower monthly payment. In addition, home prices increased dramatically, so buying a home seemed like a sure bet. Lenders understood that homes make good collateral, so they were willing to participate. Low interest rates encouraged people to buy houses. As house prices began to rise, mortgage companies relaxed their lending criteria in an effort to capitalize on the booming property market. Mortgages were sold to people with bad credit and low incomes (subprime). This subprime market expanded very quickly. In regulated markets those borrowers are high risk and would normally be charged higher interest rates and with adequate collateral to secure loans. Interest rates began to rise and housing prices started to drop moderately in 2006-2007 in many parts of the U.S., and refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated and ARM interest rates reset higher. Foreclosures accelerated in the U.S. in late 2006 and triggered a global financial crisis through 2007 and 2008. In the years leading up to the crisis, high consumption and low savings rates, contributed to significant amounts of foreign money flowing into the U.S. from fast growing economies in Asia and oil-producing countries. This inflow of funds combined with low U.S. interest rates from 2002-2004 resulted in easy credit conditions, which fuelled both housing and credit bubbles. Loans of various types (mortgage, credit card, and auto) were easy to obtain, and consumers assumed unprecedented debt loads. As a part of the housing and credit booms, the amount of financial agreements called mortgage backed securities (MBS), which got value from mortgage payments and housing prices, greatly increased. Such financial creativity enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined, major global financial institutions that borrowed and invested in subprime MBS reported significant losses. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. |