Economic Crisis Explained

How Can A few bad mortgages in the suburbs of Florida lead to the Bankruptcy of a country like Iceland? What has caused the stock market to fall by 40% -the worst decline since the Great Depression? And why has the credit crunch pushed the global economy into recession?

The Subprime Mortgage Fiasco Explained

• The Dot com bubble burst in 2001. Shares in internet companies collapsed and with events of 9/11, the US faced recession. The Federal Reserve responded by cutting interest rates to 1% - there lowest level for a long time.
• Low Interest rates encouraged people to buy a house. As house prices began to rise, mortgage companies relaxed their lending criteria and tried to capitalise on the booming property market.
• Mortgage companies actively sold mortgages to people with bad credit, low incomes - often first generation immigrants. This 'subprime market' expanded very quickly.
• Mortgage salesmen were paid on commission. Therefore, they often hid the true cost of adjustable rate mortgages and did little to check whether the homeowners could actually afford repayments in the long term. Even the feeble lending checks were ignored
• Many took out adjustable rate mortgages which were affordable for the first two years, but, then the interest rate increased making mortgage payments much more expensive.
• In 2006, inflationary pressures in the US caused interest rates to rise to 4%. Normally 4% interest rates are not particularly high. But, because many had taken out large mortgage payments, this increase made the mortgage payments unaffordable.
  
• Also many homeowners were not coming to the end of their 'introductory offers' and faced much higher interest rates. This led to an increase in mortgage defaults and companies lost money.
• As mortgage defaults increased the boom in house prices came to an end and house prices started falling.
• The falls in house prices were exacerbated by the boom in building of new homes which occurred right up until 2007. It meant that demand fell as supply was increasing causing prices to collapse, especially in suburban areas.
• The Fall in house prices made the mortgage defaults more costly. If house prices are rising and someone defaults, the mortgage company can get most of the loan back by selling the house. But, now with falling house prices, they may end up with only a fraction of the house value.
  

The Role of Credit Default Swaps

You might imagine that this irresponsible lending by US mortgage companies would mean they would go out of business - end of story. However, the problem of the US mortgage defaults was spread across the financial system.

• Mortgage companies in the US borrowed from other financial institutions to lend mortgages. They sold collateralised mortgage debt in the form of CDOs to other banks and financial institutions. This was a kind of insurance for the mortgage companies. It means that other banks shared the risk of these subprime mortgages.
• Because these subprime mortgage debts were bought by 'responsible' banks like Morgan Stanley, Lehman Brothers e.t.c. risk agencies gave these highly dubious and risky debt bundles triple A safety ratings. Thus banks either ignored or were unaware of how risky their financial position was.
• Therefore, when mortgage defaults in the US occured, many banks and financial institutions around the world had to write off bad assets. E.g. AIG had been insuring many of these mortgage debts so was faced with huge losses
• The extent of this bad debt is estimated by the IMF to be close to £1.3trillion.
  

Freezing of Money Markets.

• In addition to bad debts, the other problem was one of confidence. Because many banks had lost money and had a deterioration in their balance sheets. They couldn't afford to lend to other banks. This caused a shortage of liquidity in money markets.
• Banks usually rely on lending to each other to conduct every day business. But, after the first wave of credit losses, banks could no longer raise sufficient finance.
• For example, in the UK, the Northern Rock was particularly exposed to money markets. It had relied on borrowing money on the money markets to fund its daily business. In 2007, it simply couldn't raise enough money on the financial markets and eventually had to be nationalised by the UK government.
• Because banks were short of liquidity, they have been selling assets such as their mortgage bundles. This caused further falls in asset prices, further liquidity shortages and further deterioration in bank balance sheets. (The Paulson plan is to try to reverse this cycle by the government buying these financial assets no one else wants to buy.)
  

The Vicious Cycle of the Financial Crisis

1. Share Prices

Because banks have lost money, people have been selling shares in banks. This fall in their share prices was speeded up by aggressive 'shorting' of banking stocks. The fall in share prices have compounded the problem of banks because

1. investors / consumers lose confidence
2. More difficult to raise finance on the stock market.

Part of the UK plan is to buy bank share capital to give greater confidence to the banks and enable them to raise sufficient finance.

2. Housing Markets

The shortage of finance means that banks have had to reduce lending, especially mortgages. The shortage of mortgages has caused further falls in house prices, especially in the UK. Falling house prices are magnifying the loss of banks as more default on their mortgage and loan payments.

3. Economy

Falling house prices, shortage of finance and collapsing confidence have caused the 'real economy' to decline. Investment and consumer spending has fallen therefore major economies face recession and rising unemployment. The rising unemployment increases the chance of more mortgage defaults and further bank losses.

Further Reading

• What can we learn from financial crisis
• Different types of economic crisis
  
• A Humorous look at subprime crisis (actually quite educational)
  
• Essays on the credit crunch
• Boom and Bust in US housing market