Cause and Effect Paper - Essay Example

As the demand increased across the spectrum, housing demand was also rising. This led to an inflation of house prices which in turn attracted more and more people to buy houses as investment in property began to be considered as an investment that was bound to yield a good return. Due to the increasing demand in the economy, the US government maintained a low rate of interest so that banks could lend more – and the banks were more than willing to lend to finance this consumer demand as it meant greater profits for them.

Statistics suggest that the total loans outstanding for banks increased from 99% of GDP in 2000 to 132% of GDP in 2007. Mortgage loans also saw a similar increase in lending – from 48% of GDP in 2000 to 73% of GDP in 2007 (McKinsey, 2010). During this period, as bank lending increased, the focus of banks began to shift from looking at the fundamentals of lending to looking at volumes and profitability of loans. Therefore, they started lending heavily to subprime borrowers - borrowers with a poor credit rating - and these borrowers were attractive for banks as they could charge a higher rate of interest to these customers.

In order to hedge against these risky loans, the banks also started selling Mortgage Backed Securities (MBS) which were bonds payable against receipt of housing loan installments. The increasing demand of loans led to an increase in interest rates for lending. As a consequence, financing and refinancing became costlier and loans were no longer easily available to pay installments or to fund further demand. This caused a reduction in demand in the housing sector as well. With a reduced demand, the prices of houses stopped increasing – in fact, they began to fall.

Now, subprime borrowers found it increasingly difficult to sustain their installment payments as the value of their assets (house prices) began to run below their liabilities (loans outstanding). This further caused them to default on their payments. This defaulting of payments had two important effects – banks lost the money they had lent and had to write off the loans, and MBS were no longer paying the return they promised to pay. As a result, insurers and investment banks who had promised payments in case of failure of these MBS incurred huge losses.

All financial institutions had to suffer these losses and the worst hit were banks like Citibank, insurers like AIG, and investment banks like Lehman Brothers. Due to these losses, consumers lost confidence in several of these financial institution and most banks saw a bank-run – when depositors line up outside banks to demand their deposits. In the end, some of these companies had to shut down, and many other financial institutions had to be bailed out by the US government to keep them running.

All of this, led to a severe downturn in the US economy. Another important implication of this downturn was that the credit rating agencies were blamed for not being proactive and reviewing properly their ratings for the financial companies. This downturn led to companies reducing their costs to stay profitable. They did so by firing their staff and by stopping their recruitment. Consequently, unemployment started to increase in the US economy reaching 9% which led to further lowering of consumer confidence and demand.

In order to prevent the situation from getting worse, the central bank reduced its interest rate to near zero level and increased the money supply heavily. However, due to