Sunday, January 2, 2011

Causes of Financial Crisis

A report into the recent US financial crisis makes grim reading.
"There are 26 million Americans who are out of work ... Nearly $11tn in household wealth has vanished ... The collateral damage of this crisis has been real people and real communities. The impacts of this crisis are likely to be felt for a generation."

"But underneath, something was going wrong. Like a science-fiction movie in which ordinary household objects turn hostile, familiar market mechanisms were being transformed. The time-tested 30-year fixed-rate mortgage, with a 20% down payment, went out of style. There was a burgeoning global demand for residential mortgage–backed securities that offered seemingly solid and secure returns. Investors around the world clamored to purchase securities built on American real estate, seemingly one of the safest bets in the world." (excerpts from Report)
The report concludes that a serious of avoidable failures contributed to the worst financial and economic crisis since the war. In essence, the main failings were:
  • Widespread failures in financial regulation, including the Federal Reserve's failure to stem the "tide of toxic mortgages".
  • Firms too willing to take unjustifiable risk. Debt levels held by financial sector in US rose from £1.9tn to £22.5tn between 1987 and 2007.
  • Householders too keen to take tempting mortgage offers they had
  • Sub-prime mortgages went from 5% of loans in 1994 to 20% in 2006. Yet, sub-prime mortgages were often sold in the knowledge borrowers wouldn't be able to afford it.
  • Failure by regulators to prevent these damaging practises in the mortgage industry.
  • Policymakers who were ill-prepared for the crisis and lacked a "full understanding of the financial system they oversaw".
  • Systemic breaches of accountability and ethics at all levels. Mortgage-holders took out loans they never intended to pay; lenders made loans they knew the borrowers could not afford.
In addition, the Credit rating agencies deserved condemnation for their failure to adequately assess the risk of sub-prime mortgage bundles.

Currently, banks are self-regulating themselves. But committee member Byron Georgiou said: "Our financial system today is not very different today than it was in the run-up to 2007.... it would be remiss to suggest whatever failing we uncovered"

The main area of controversy was the issue of Government agency Fannie Mae and Freddie Mac. Republicans argue that the attempt by government to encourage mortgage lending to people on low incomes was a major factor in the unsustainable boom. Others point out that in the height of the boom, Fannie Mae and Freddie Mac actually reduced their share of mortgage lending, and didn't get involved in the sub-prime mortgage sector. (Karl Smith -Freed Mac and Fannie Mae acquitted)

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