Sub-Prime Crisis and its Major Causes and Consequences - Book Report/Review Example

 Business Report: Sub-prime crisis Table of contents 1. Summary : page 3 2. Introduction : page 4 3. Major causes and consequences of the recent subprime crisis : page 5 4. How does securitization affect the sub-prime crisis? : page 11 5. Conclusions : page 12 6. Recommendations : page 13 7. References : page 15 Summary The recent financial crisis is referred as subprime crisis by the economists because of the huge role banks played in contributing to this crisis. The immature and uncontrolled lending habits of the financial institutions in the western countries like America, United Kingdom and other European countries contributed heavily to the recent subprime problems. People approached the financial institutions whenever they were in need of money and these institutions was ready to allot them loans even with proper assessment of the borrower’s abilities of repayment. Banks thought that the global economy was stable and renewable so that they can give loans to anybody who is in need. Securitization was also a major reason for the current subprime problems as the banks had no control, whatsoever over the money they granted as loans. Instead of utilizing the money in the productive sector, people burned the borrowed money in the non productive sector which resulted in the recent subprime crisis. Introduction Even though the terms financial crisis, economic crisis and recession are quiet familiar to the ordinary people, the term subprime crisis is not so to the layman. The current financial crisis is often referred as subprime crisis. The term subprime means, giving loans to consumers who are in the riskiest category. The standards for determining risk categories depend on the size of the loan, structure of the loan, borrower credit rating, a ratio of borrower debt to income or assets, ratio of loan to value or collateral, and documentation provided on those loans which do not meet etc. Even though there is no standard definition for subprime loans or lending, generally it is accepted that loans given to a borrower with a FICO score below 640 is a subprime lending. FICO score is calculated based on the consumer’s credit details. August 9, 2007 and August 4 1914 have some resemblances as far as financial markets are concerned. On these dates world witnessed the end of prosperity in economic market and the beginning of credit crunch (Special report: Credit crisis - how it all began, 2008). The current credit crunch came at an unexpected time, in 2007. Subprime crisis is the ongoing real estate crisis and financial crisis dramatically appeared in global market generally and US market specifically in the form of mortgage delinquencies, foreclosures, overheating of real estate and debt markets etc. The house prices in United States peaked in 2006 and thereafter it marked a steep decline indicating the beginning of subprime crisis. The article Statistics change linked to subprime crisis (2009) has mentioned the role of low inflation in causing subprime crisis. Lenders wrongly calculated that they can offer loans at the rate of even 5 and percentages because of low inflation. Such tactic s actually resulted in high amount of speculation in the market that the home prices may go up even further. Thus home buyers forced to buy more and more expensive houses. The low interest rates served as the biggest motivation for the home buyers. Moreover, home buyers could have refinance their houses because of the skyrocketing home prices. But once the home prices got stabilized or declined, both the lenders and the borrowers started to face troubles (Statistics change linked to subprime crisis, 2007) Even though many reasons were cited for the subprime crisis, the major reasons for the credit crunch were the unwise policies implemented by the banks and the government as far the subprime lending is concerned. Securitization is another major factor which contributed heavily to the recent subprime crisis. Cohan (2007) defined securitization as the “financial innovation" which allowed the banks to “make loans and then sell them to someone else”. In his opinion, it is important for the banks to retain certain amount of money as capital if they want to make more loans (Cohan, 2007). Securitization enabled the banks to give loans as much as they wish. The greedy banking people thought that the economy will never collapse and they can make more money through subprime lending. This paper briefly analyses the major causes and consequences of the recent subprime crisis and the role of securitisation in worsening the problem. Major causes and consequences of the recent subprime crisis The figure given below indicates the new model of mortgage lending. It is clear from the figure that the financial institutions forced to tighten their norms of mortgage lending as aresult of the recent subprime crisis. The major reason for the recent financial crisis was the unwise lending habits of the financial institutions. “Banks found ways to increase the number of mortgage loans through strategies such as interest only mortgages, 100% mortgages and lending to people with poor credit histories” (Who is to Blame for Credit Crunch?, n. d.). American and UK public have the habit of spending lavishly and they don’t bother about saving anything for the future. When they were in need of money they approached the banks and the banks were ready to give them loans as much as they required, without assessing their financial capabilities. Banks never calculated that an economic crisis like the current one may happen in near future THE NEW MODEL OF MORTGAGE LENDING Top of Form Bottom of Form (BBC News, 2007) When banks tried to increase their profitability though increased lending, the difference between base rates and bank rates increased a lot and the cost of arranging fixed rate mortgage has also increased (Problems of Credit Crunch, 2009).The banks prepared many policies to attract customers and also to increase their lending business. They reduced the interest rates on mortgages which encouraged the people to go for buying expensive houses. Normal people calculated that the economy is so strong so that they can afford to buy expensive goods. Moreover congress has given tax reduction to those who were buying expensive houses in order to stimulate the real estate sector. In short, both the Congress and the financial institutions contributed heavily to the public attitude of seeking loans for everything they were in need. Congress and the Government failed to analyze the economic situations properly. They trusted the abilities of the banks in analyzing the financial situation and did nothing either to control or stop the heavy mortgages given by the banks. Elliot (2008) has pointed out that the fiancé ministers all over the world are in a difficult situation not only because of the credit crunch, but also because of the rising inflation. He has also mentioned that high inflation was the bi-product of increasing crude oil prices. If the crude oil price was $ 70/barrel in 2007, it was doubled in 2008. Rising food prices increased the cost of living an hence it was difficult to digest the decision of the banks to cut in interest rates according to Elliot (Elliott, 2008). The financial institutions need to be blamed themselves for the current crisis. The crazy lending habits of the banks without assessing the financial capabilities of the loan seekers have contributed a lot to the current financial crisis. The current subprime crisis is witnessed only as a beginning by many of the economists. It can be solved one day, but the situation following that may be most probably even worse. The reasons for the current crisis may not be due to the policies alone. The Federal Reserve has made the credit cheap and the home buyers took advantage of the easy lending policies of the banks. Most of the real estate agents worked for the sellers rather than the buyers in order to earn higher commission fees from selling more expensive homes. Bianco, (2008) has blamed wall street firms for the current crisis. In his opinion, these firms was not given proper attention to the “quality of the risky loans that they bundled into Mortgage Backed Securities (MBS), and issued bonds using those securities as collateral” (Bianco, 2008). Even though the American banking crisis is dangerous, the condition of global economy is more dangerous than the banking crisis. Many economists believe that the current recession may continue longer than anticipated. Inman (2009) has mentioned that the house prices in Britain have already reached an time low and it is going to be lowered again (Inman, 2009) The life style of American people is entirely different from that of some other countries like India or Japan. They believe more in spending rather than saving. They approach the financial institutions for loans whenever they are in need of bulk amount of money and the American banks had no hesitation in giving loans to the borrowers irrespective of their financial abilities. When the recession started to rise in the horizon, banks started to press the borrowers to repay the loans, but their economic conditions were not so good for the repayment of the loans which resulted in collapses of some of the reputed banking institutions such as Bank of America, Citigroup, Wells Fargo and J.P. Morgan Chase Bear Stearns, Lehman Brothers etc. The following figure shows the rise of the mortgage market from 1996 to 2007. It is evident from the figure that the government backed mortgages increased gradually from 1996 to 2007. (BBC News, 2007) BBC News dated 21 November, 2007 pointed out the intrusion of private sector in the mortgage bond market in the last five years which brought many new products in the mortgage market. These products were designed for borrowers with even poor credit histories and weak income which ultimately resulted in the subprime crisis (BBC News, 2007). These new products were introduced into the market without careful evaluation about the consequences of them. The private agencies had the intention to increase their profit as much as possible and for that purpose they did everything possible to attract all the people irrespective of their financial abilities. The government and the policy makers kept a blind eye towards such visionless lending of private agencies as the government thought that increased lending may increase the economic activities and hence the economy may grow rapidly. (BBC News, 2007) The financial institution like banks miscalculated the global economy as a renewable source of income and they never expected it as a bubble. They miscalculated that the global economy will never exhaust and whatever the goods and services sold in the market will bring profit. Such irresponsible allocation of resources by the banks in the market is the main cause of the current subprime problem. The banks have given more focus to the goods or services they sold whereas they have given least importance to the services they bought. Once the balance between the services sold and bought was destroyed, financial crisis came into the picture. Most of the banks neglected the importance of supply-demand theory of economics while they approved the loan applications. According to the supply demand theory, the demand should be properly assessed before providing enough supply to the market and banks failed to obey the above principle which is another reason for the subprime crisis. Subprime lending statistics in Cleveland metro area is given in the figure below. It is evident from the figure that almost the entire population in Cleveland metro area were one way or other taken loans from banks. (BBC News, 2007) How does securitization affect the sub-prime crisis? Securitization was another major reason for the subprime crisis. It enabled the banks to give loans as much as they wish. Cohan (2007) has mentioned that “there were hundreds of billions of securities backed by credit card receivables, auto loans, and leveraged buyout loans whose problems have yet to surface” (Cohan 2007). Economists have different opinions about the role of securitization in causing current subprime crisis. In their opinion, securitization is a failed concept. Barr (2007) has mentioned that securitization concept failed because of the excessive subprime lending (Barr, 2007). At the same time it is a fact that the economy cannot develop properly in the absence of securitization. It helps lenders to control their business more efficiently by selling loans rather than keeping the money in their shelves. Money will have only paper value when it is kept unused whereas its real value will come into effect when it is used. Under such circumstances, the banks cannot enforce tight control over lending. Wyplosz (2007) has argued that securitization failed because of the repeated selling of the loans taken from the banks. In his opinion, banks failed to enforce proper control over the loan money since the borrowers sold the loans to other persons (Wyplosz, 2007). In short, securitization enabled the institutions to take loans from banks and sell it to others. Thus the banks were unable to verify how well the borrowers utilized the loans taken from them. In other words, securitization resulted in banks losing control over the loans they allotted which is not a good thing. Conclusions The current financial crisis is aroused mainly because of the immature lending habits of the banks. The public contributed heavily to the subprime crisis by taking huge amounts of leans from the banks even for unnecessary things. The banks had little control over the loans they sanctioned as those who took the loans from the banks sold it to others for better margins (securitisation). Banks miscalculated that the global economy is renewable and there is no harm in lending as much as possible. Banks failed to supply loans based on the demand. In fact they allotted more money than the actual requirements in the market which ultimately resulted in the current subprime crisis. Governments failed to enforce control over the lending habits of financial institutions. They thought increased lending may result in allocation of more money in the productive sector and thereby the economy could be grown significantly. But instead of spending money in the productive sector, people in the countries like US and UK lavishly spent the money they borrowed in the non-productive sector. Recommendations Davis (2009) has pointed out that the current subprime crisis caused not because of lack of cleverer people, but because of the lack of strategies (Davis, 2009). The recent subprime crisis was happened not because of the inefficiency of the bank executives, but because of the greedy profit making mottos. These people should realize that the economic bubble can burst any time; sometimes even unexpectedly. So they should take extreme precautions while giving loans to the public. The financial abilities of the public should be accurately assed before sanctioning the loans to them. Banks should make sure that the borrowers repay the loans without any interruptions. Moreover they should also ensure that the borrowers have enough property wealth so that in case of a crisis they can sell such properties and repay the loans. Government should control the banks and their lending habits to avoid further financial crisis. The globalization and liberalization policies should be modified and carefully formulated so that the interests of the country would not be sacrificed. The financial institutions should investigate the financial abilities of the loan seekers before allotting the loans. Americans and the British should learn lessons from India and China like heavily populated countries. References 1. BBC News, (21 November, 2007), The downturn in facts and figures, [Online], Available at: http://news.bbc.co.uk/2/hi/business/7073131.stm[Accessed 10 October 2010] 2. Barr, A (2007), Subprime test: Did securitization work?, [Online], Available at: http://www.marketwatch.com/story/toxic-test-did-securitization-work-in-subprime-crisis [Accessed 10 October 2010] 3. Bianco, K M. (2008), The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown. [Online], Available at: http://www.business.cch.com/bankingfinance/focus/news/Subprime_WP_rev.pdf [Accessed 10 October 2010] 4. Cohan, P. (2007), Record $300 billion loss in credit to crimp economic growth, [Online], Available at: http://www.bloggingstocks.com/2007/11/28/record-300-billion-loss-in-credit-to-crimp-economic-growth/[Accessed 10 October 2010] 5. Davis, E. (2009), The rocket scientists of finance”. [Online], Available at: http://news.bbc.co.uk/2/hi/business/7826431.stm [Accessed 10 October 2010] 6. Elliott, L (2008), Special Report: Credit Crisis - how it all Began, The Guardian, Tuesday 5 August 2008 [Online], Available at: http://www.guardian.co.uk/business/2008/aug/05/northernrock.banking [Accessed 10 October 2010] 7. Inman P, (2009), Unemployment will soar above 3 million in 2009, say chambers of Commerce, [Online], Available at: http://www.guardian.co.uk/business/2009/jan/01/unhappy-new-year [Accessed 10 October 2010] 8. Problems of Credit Crunch, (2009), [Online], Available at: http://www.economicshelp.org/2008/07/problems-of-credit-crunch.html [Accessed 10 October 2010] 9. Statistics change linked to subprime crisis (2007), Denver Business journal, September, 21, 2007. 10. Who is to Blame for Credit Crunch? (n. d), [Online], Available at: http://www.economicshelp.org/2008/08/who-is-to-blame-for-credit-crunch.html [Accessed 10 October 2010] 11. Wyplosz, (2007), Subprime 'crisis': observations on the emerging debate [Online], Available at: http://www.voxeu.org/index.php?q=node/471 [Accessed 10 October 2010] Read More