The Financial System Crisis of August 2007 - Essay Example

This category is the most risky element of the mortgage market and over-exposure to this segment put banks in high risk. Although the sub-prime mortgage market in the United States constitutes only a small proportion of the entire market, the uncertainties related to the liquidity of the banks' financials took the situation to critical levels. On August 31, 2007, Federal Reserve Chairman Ben Bernanke noted that "[a]lthough this episode appears to have been triggered largely by heightened concerns about subprime mortgages, global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans" (Open CRS, 2007).

Suddenly, there was a loss in liquidity in all financial markets in the US, including the securities markets. Fears of risks began to grow and most financial institutions began to invest in the safest financial instrument, that is, US Treasury Bonds. Even the market for commercial paper nearly froze as a result of which large corporations found it difficult to raise funds for their day-to-day operations (Beams, 2007). The real cause of the crisis may be traced back to the rise in the housing credit market boosted by low interest rates since 2000.

In order to boost consumer spending after the dotcom bust of 2000, interest rates were lowered. As a result, not only did people begin to buy more houses, they also refinanced the property to with further mortgages. As a result, consumer spending in the economy grew phenomenally and savings petered. By the beginning of 2007, defaults on loans began to grow, reaching 30 percent higher than what it was a year ago and credit card companies had to write off 4.8 percent of the receivables (Beams, 2007).

Many sub-prime lenders like New Century Financial Corporation had to file for bankruptcy following a significant amount of foreclosures as a result of default on payments (wikipedia) and on the whole stock prices of mortgage companies were the first to be affected. Analysts have argued that the roots of the financial crisis of August 2007 originate from the global economic trends over the last decade. Globalization and inter-linkages of financial markets have resulted in heightened uncertainties and global financial imbalances.

The US government finances have turned from surpluses in the 1990s to a deficit, public debt being 64.7 percent of GDP in 2005, close to what it is in other industrialized countries (CIA). This has largely been the result of tax cuts in the past, in order to boost growth since the dotcom bust in 1999-00, as well as increased outlays for defense and military spending necessitated by rise in terrorism at home as well as initiatives in the middle East. Hence, the fiscal policy that spurred economic recovery resulted in rise in interest rates (Muhlesein & Towe, 2004).

The US monetary policy has largely supported the fiscal policy-induced growth. The growing current affairs deficit of nearly 7 percent of GDP, that is the deficit between what the country earns abroad and what it spends, has been a cause for concern. US external debt has been close to 25 percent of GDP for over two years (Setser et al, 2005). Much of this deficit is financed by foreign central banks subscribing to US Treasury Bonds, particularly the central bank of China, which has had the fastest growth among all