The stock price plunge and the severe credit crunch we are watching today in the global financial markets are byproducts of the developments in the US six years ago. In late 2001, fears of global terror attacks after 9/11 shook an already struggling US economy, one that was just beginning to come out of the recession induced by the bursting of the dotcom bubble of late 1990s.
In response, during 2001, the Federal Reserve, the US central bank, began cutting interest rates dramatically to encourage borrowing, which spurred both consumption and investment spending. As lower interest rates worked their way into the economy, the real estate market began to get itself into frenzy. The number of homes sold and the prices they sold for increased dramatically, beginning in 2002. At the time, the rate on a 30-year fixed rate mortgage was at the lowest levels seen in nearly 40 years. Subprime lending and similar mortgage originations in the US rose from less than 8 percent of all mortgages in 2003, to over 20 percent in 2006.
The crisis began with the bursting of the US housing bubble and high default rates on subprime and adjustable rate mortgages, beginning in approximately 2005-2006. For a number of years prior to that, declining lending standards, 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 they would be able to quickly refinance at more favorable terms.
However, once interest rates began to rise and housing prices started to drop in 2006-2007, in many parts of the US, refinancing became more difficult. Default and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and adjustable rate mortgage interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008.
Initially the companies affected were those directly involved in home construction and mortgage lending. Financial institutions, which had engaged in the securitization of mortgages, fell prey subsequently.
The initial liquidity crisis can in hindsight be seen to have resulted from the incipient subprime mortgage crisis. One of the first victims outside the US was Northern Rock, a major British bank. The bank's inability to borrow additional funds to pay off maturing debt obligations led to a bank run in mid-September 2007. The highly leveraged nature of its business, unsupportable without fresh infusions of cash, led to its takeover by the British Government and provided an early indication of the troubles that would soon befall other banks and financial institutions.
Excessive lending under loosened underwriting standards, which was a hallmark of the United States housing bubble, resulted in a very large number of subprime mortgages. These high-risk loans had been perceived to be mitigated by securitization. Rather than justifying the risk, however, this strategy appeared to have had the effect of broadcasting and amplifying it in a domino effect. The damage from these failing securitization schemes eventually cut across a large swath of the housing market and the housing business and led to the subprime mortgage crisis. The accelerating rate of foreclosures caused an ever greater number of homes to be dumped onto the market. This glut of...