An unconventional Economic Notion

Written by Mashud Abukari

The recent financial crisis and the downturn in the U.S. economy which began during late 2007, traces its roots back to the early 2000s. In 2001, the U.S. economy experienced a mild, short-lived recession due to the dotcom bubble burst, the impending September 11 terrorist attacks and the infamous accounting scandals. In response, the Federal Reserve stimulated the economy to hold off a recession. Central banks around the world also followed up by engaging in accommodative monetary policies to create capital liquidity through reduction of interest rates. The lower interest rate environment expanded the money supply encouraged borrowing, which spurred spending and investment. It set the stage for the prelude of the subprime mortgage bubble. As investors searched for higher returns through riskier investment and lenders took more risk by approving subprime mortgage loans to borrowers with poor credit, the subprime bubble inflated. Consumer demand also fueled the housing bubble which ultimately busted in August of 2006.  The major players were: the Lenders, Homebuyers, Investment Banks, Rating Agencies, Investors and the Regulators.

Lenders:
The lenders were ultimately responsible for creating the problem: they lent funds to people with poor credit and high risk of default. When central banks flooded the markets with capital liquidity by lowering interest rate, the risk premiums was also lowered which resulted in investor appetite for risker opportunities to increase returns.  At the same time, lenders found themselves with ample capital to lend and, like investors, an increased willingness to undertake additional risk to increase their investment returns.[1] Lenders became aggressive underwriters of subprime loans, partly due to the increase in demand for mortgages and the rise in house prices.

Homebuyers:
Homebuyers also contributed to the problem by purchasing houses they could not afford. Home owners were attracted to the low interest rate environment like the 30-year fixed rate mortgages. It became a unique opportunity for buyers to gain the source of equity. Non-traditional mortgages such as the adjustable-rates and interest-only mortgages made the proposition more appealing to homebuyers. Lenders offered low introductory rates and lowered the minimal initial cost. This cycle continued temporarily, as house prices appreciated and homeowners refinanced at lower rate, until the housing bubble burst and prices dropped rapidly.

Investment Banks: Facilitator
The increased use of the secondary mortgage market by lenders added to the number of subprime loans lenders could originate¹. Investment banks picked up the rod from the mortgage originators and securitized the mortgages, which were then sold to investors. The primary business of the lenders was transformed from holding mortgages on books to originating loans. Lenders simply sold off the mortgages in the secondary market by securitizing the bonds through the help of Investment banks and then collect originating fees.

Credit Rating Agencies:
The rating agencies were the rubber-stamper for the securitized mortgages. They were complicit in the subprime crisis because they gave triple A ratings to many of the securities that included subprime loans. The boom in the mortgage-back securities was partly because the rating agencies gave investors the green light for investors to purchase. Therefore, the increased demand for these securities resulted in the creation of more and more subprime loans.

The Overseers: Government
The policies of the government over the past decade made the grounds possible for the financial crisis. Among the laws include the Community Reinvest Act which increased bank lending to low income areas and the deregulation of the financial markets. These policies fostered lower credit requirement, lower down payment and facilitated the development of new financial products like credit default swaps.

The unusual low interest rates inaugurated by Alan Greenspan, Federal Reserve Chairman during the bubble period and the hands-off approach to regulation also contributed to the problem.

The End of Easy Credit:
The first sign of the crack was halt in new home sales, the decline in price of houses and the rise in the default rate on mortgages. Mortgage lenders source of funding, the secondary market, was cut off because of the decline in appetite, as a result CDOs became unmarketable. This ultimately resulted in the credit crunch in the financial market.

Policy Response:
Central banks around the world and the Federal Reserve took steps to address the crisis in the financial markets. To help stem the impact of the crunch, the central banks injected billions of dollars, assisted banks with liquidity issues to help stabilize the financial markets. The Federal Reserve cut the discount window rate and the Federal funds rate, which made it cheaper for financial institutions to borrow funds from the Fed. It also added liquidity to their operations of financial institutions to help struggling assets.[2] The Federal policy actions during the downturn included the creation of lending facilities to enable the Fed to lend directly to banks and non-bank institutions, $600 billion program to purchase MBS of the GSE and the increase in the size of the Federal Reserve’s balance sheet through Federal Open Market Operations. In addition to adjustment of monetary and fiscal policy decisions have been enacted by federal government to ease the ongoing crunch.

References:

Barnes, Ryan. “The Fuel That Fed The Subprime Meltdown.” Investopedia. 4 Sept. 2007. Web. 13 Dec. 2011. <http://www.investopedia.com/articles/07/subprime-overview.asp>.

Petroff, Eric. “Who Is To Blame For The Subprime Crisis?” Investopedia. 5 Sept. 2007. Web. 13 Dec. 2011. <http://www.investopedia.com/articles/07/subprime-blame.asp>.

Simpson, Stephen D. “5 People Blamed For The Financial Crisis – Investopedia.com.” Financial Edge – Investopedia.com. 17 Feb. 2011. Web. 14 Dec. 2011. <http://financialedge.investopedia.com/financial-edge/0211/5-People-Blamed-For-The-Financial-Crisis.aspx>.

Singh, Manoj. “The 2007-08 Financial Crisis In Review.” Investopedia. 14 Jan. 2009. Web. 13 Dec. 2011. <http://www.investopedia.com/articles/economics/09/financial-crisis-review.asp>.