Sub-Prime Mortgage Crisis - What Caused It ? How Can Us Recover from It?

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Sub-Prime Mortgage Crisis - What Caused It ? How Can US Recover From It?

The recent financial crisis in the U.S. that spread to other countries and caused massive turndown in the global economy had its roots in the recent waves of globalisation. Since the developed countries’ production had shifted dramatically towards services, specially to financial services, and this in turn led to financial liberalizations, developed countries experienced massive capital inflows, lending booms, housing and / or stock market bubbles. Financial crises are usually followed by hard and sharp contraction in economic activities, which requires government intervention to bail out banks and restore banking stability. However, government intervention increases national debt, which will normally be paid later by increasing taxes. In this paper, we look at some of the causes of the U.S subprime mortgage and the resulting financial crisis. A point of departure for our analysis is to note that the potential losses from the U.S subprime mortgage were not indeed that large. As Fredrick Mishkin (the former Governor of the federal reserve) stated “The ultimate losses from the recent residential mortgage market meltdown have been estimated by Wall Street analysts at about $500bn- less than 3% of the outstanding $22 trillion in the US equities. Why did a relatively small amount of losses in subprime mortgage loans led to such broad-based financial disruption? ” We surely witness similar declines and losses in stock markets on a daily basis but such losses never lead to a financial meltdown, and have little impact on the economy. We will review the reaction of the market to the crisis and some of its consequences. We will further investigate how can the US economy possibly recover from it?

A multitude of factors seem to have contributed to the US subprime mortgage crisis, including the 1998 financial crises in the south East Asian countries, increasing globalisation and trade liberalisation, U.S domestic policies and, more importantly, a new banking model. We start with a brief analysis of the role the modern banking model played in the development of the crisis and then try to explain how the subprime losses led to a full-blown financial crisis, which caused the global economic stagnation.

In the traditional banking model, depositors used to put their money in banks, banks kept 10% of the savings with the central bank and lent the rest in the form of loans. The borrower who intended to buy a house, had to have at least 10% value of the asset to receive the mortgage, which would be paid back in about 20 years or so. In this model of banking, capital was inefficiently locked in the form of mortgages or other long-term loans. A bank should have typically waited for 20 years or so to have the capital fully back. To overcome the inefficiency of the old banking system and to unlock the capital and distribute risk, in the last few decades banks adopted a new business model – the originate-to-distribute banking model. As a results, banks started to combine high risk mortgages and low risk mortgages together, securitized and sold them to investors. And by doing this, they managed to circulate the capital in the banking system more frequently, which in turn increased the liquidity and credit in the banking system(Brunnermeirer, M.K., 2009). The rise in liquidity put downward pressure on the interest rates. Lower interest rates made mortgages more affordable, increased the demand for houses, and thus led to a rise in the house prices. The steady rise in the house prices raised the collateral value of the houses, enabling owners to remortgage or change their houses, further fuelling the house prices. (D.W.Diamond, 2009)

The boom in house prices, a rising belief in the safety of structured financial products, and the AAA ratings of most structured securities by the rating agencies encouraged pension funds and other financial intermediaries to invest in...
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