Global Credit Crisis
During the same time frame i.e. from mid 90s up to the mid 2000s, housing prices in the US continued to increase at a stable rate and allowed home owners to apply for refinancing and new mortgage agreements with banks simultaneously once the prime market had been saturated banks went on to give loans in the subprime mortgage market which was not only untapped but also offered higher interest earnings as subprime borrowers were liable to pay more since they were considered riskier borrowers compared to prime borrowers. In such a market environment a lot of banks were exposed to risky loans lend out because other markets had been catered too or were considered not viable.
Sub-Prime Mortgage Crisis
The subprime mortgage crisis was the beginning of the credit crunch period. The early casualties were Northern Rock bank in England and AIG, Citigroup in the US. In simple terms to understand the sub-prime mortgage crisis we need to have a look at how financial products are sold between financial institutions. In very basic terms financial institutions such as banks prepare certificates, bonds and derivative products. More specifically banks created CDOs (Collateralized Debt Obligation) a product from a family that provided income from underlying assets. What banks did was that they used different mortgage papers of home owners and created tranches or slices of mortgaged paper to create a new asset. This new asset was a collection of tranches which covered different kinds of mortgages. Some of these mortgages were also from the subprime market.
Banks were selling these CDOs or tranches of mortgages to other financial institution for instance foreign banks, investment banks, insurance companies and so on. The principle was that payments from home owners will be used to provide for the payments of these CDOs and in the mean time banks would free up tied capital which was initially loaned out to home owners. (Financial Times, 2009)
In theory this seems to be a very good plan and many bankers though likewise but in practice what they did not realize was the fact that what if home owners default on payments What if they are unable to meet their liabilities toward other financial institutions The fallout was horrific for the banking industry of the US and many European banks with investments in US bank products. When subprime mortgage owners failed to meet their obligations and defaulted, banks intervened and forced foreclosure this meant that slowly as more and more people defaulted because of difficulties in the job market (as the manufacturing sector was in decline too) and higher interest rates there were a greater number of homes up for sale. This increased supply of home loans reduced the prices of homes and hence the book value of many banks balance sheets. (Bloomberg, 2009)
Another fallout was that payments in lieu of CDOs were not being fulfilled which led to more banks and financial institutions writing off losses. This could also be explained as a domino effect ultimately many banks filled for bankruptcies because of their large exposure in such products. Some of the failed banks and institutions were so big that governments worldwide could not afford to let them fail or go out of business. Prominent examples include AIG and Citigroup. (The Economist, 2008)
Predatory lending
This type of lending introduced the practice where illegal lenders entered into questionable and financially unsafe loan agreements for misappropriation purposes. An example of such lending was Countrywide Home Loans who although advertised their home loans at very low interest rates say 1 to 1.5 but in reality forced consumers to get trapped in an Adjustable rate mortgage (ARM) according to which the interest actually charged was much more than initially advertised. This resulted in negative amortization.
Negative amortization is method of amortization where the loan payment due in a period becomes less than the interest to be charged over that period, this significantly increases the total outstanding loan owed by the consumer and hence further burdening the consumer with the increased debt. Eventually consumers defaulted hence further deteriorating the financial position of Countrywide.
Effects on wealth
The wealth of nation population along with consumption, investment in businesses and government spending run its economic engine. In the aftermath of the global credit crisis, Americans in 2007 lost 25 of their net worth on an average basis. Similarly, the SP 500 index dropped by 45 in 2008, gross home equity fell by 48 in mid-2008 and continued to falter later in the year and early 2009.
Gross retirement assets also dropped by 22 to 8 trillion in 2008. Furthermore savings and investment assets along with pension assets suffered a combined loss of 8.3 trillion.
Deregulation
Although the sub prime mortgage and predatory lending had already paved the way for a disastrous economic crisis but deregulation on the US governments part further fuelled economic crisis.
However the deregulation didnt take place during the financial crisis but were in fact a result of steps taken by the US government over the last decade or so.
Corrective Measures and Policies
Governments worldwide had to react as failing financial sector firms were causing other industries to suffer these firms in other industries were dependent on critical cash flow and credit from the banks. Another issue was that job losses were rising causing public anger and frustration.
Governments worldwide rolled out bailout packages for failing banks and companies in sectors which were too important for each respective economy. For instance the American government bought major stakes in Citigroup and gave a huge loan of over 80 Billion dollars to AIG. The fact of the matter is that by providing cash and buying toxic assets from banks governments will not solve the real problem. The major reason for the credit crunch was the incompetency of the many American bankers who did not realize the fallout of complex SPVs, and CDOs and the like which were extremely over leveraged and mortgage backed loans sold to people who could not have paid the loans back.
We believe that the Chinese can lead the recovery of the global financial crisis and they have already given the way of handling the crisis. If we look at the chart below it is evident that the savings ratio of the Chinese has increased steadily versus there GDP hence banks have more money to lend to businesses and this would eventually increase the total investment in the country and subsequently in the world.
Source httpwww.alwaysthetwain.comblogswp-contentuploads200907china-savings-vs-spending-rate.png
An important deduction is also the fact that long-term investments increase the chances of consumption in the future. Banks in the US need to follow this model by offering more attractive savings products rather than continually focusing on loans.
Conclusion
The present US government is hinting toward tough regulations for the financial sector and even tougher stance against the bankers community though we support the idea of more responsible regulations and a tough stance against the products being offered but the critical policy that will resolve the issue is not related to the monetary policy and regulation at wall street rather we will have to keep a look out for the way the US government encourages consumer spending or a culture of savings.
An important factor is the way the American government will spend the rest of the bailout package money it is essential to understand that banks will be pressurized by the present Obama government to contract their operations and reduce the amount of risky products and there undue to risk. The bailout package has an excess liquidity problem attached to it that is too much of the taxpayers money spent on increasing consumer expenditure could result into a weak recovery and short-term approach to the greater problem at hand. It is therefore crucial to have appropriate exit strategies in place to stimulate and provide only enough cash which could provide the needed stimulus.
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