Money Crisis 2007-08 in the US - Essay Example

and Section # of What is Money Crisis A money crisis refers to a sudden shortage of funds for lending, leading to a resulting decline in loans available (Shah). A money crisis can occur for various reasons: Sudden increase in interest rates (e.g. in 1992, UK government increased rates to 15) Direct money controls by the government (rarely used by Western Government's these days) A Drying up of funds in the capital markets (Shah) The recent money crisis was driven by a sharp rise in defaults on subprime mortgages. These mortgages were mainly in America but the resulting shortage of funds spread throughout the rest of the world (BBC). The 2007-08 Money Crisis US mortgage lenders sell many inappropriate mortgages to customers with low income and poor credit. It is hoped with a booming housing market, the mortgages will remain affordable. Often there were lax controls in the sale of mortgage products. Mortgage brokers got paid for selling a mortgage, so there was an incentive to sell mortgages even if they were too expensive and high chance of default (Mortgage Guide). To sell more profitable subprime mortgages, mortgage companies bundled the debt into consolidation packages and sold the debt on to other finance companies. In other words, mortgage companies borrowed to be able to lend mortgages. For example, the lending was not financed out of saving accounts (Mortgage Guide). These mortgage debts were bought by financial intermediaries. The idea was to spread the risk, but, actually it just spread the problem. Usually subprime mortgages would have a high risk assessment rating. But, when the mortgage bundles got passed onto other lenders, rating agencies gave these risky subprime mortgages a low risk rating. Therefore, the financial system denied the extent of risk in their balance sheets (Mortgage Guide). Many of these mortgages charged a balloon interest rate in which, they charge low interest rates in the initial period, but at the end of the introductory period interest rates rise rapidly (Mortgage Guide). In 2007, the US had to increase interest rates because of inflation (BBC). This made mortgage payments more expensive. Furthermore, many homeowners who had taken out mortgages two years earlier now faced ballooning mortgage payments as their introductory period ended. Homeowners also faced lower disposable income because of rising health care costs, rising petrol prices and rising food prices. This caused a rise in mortgage defaults, as many new homeowners could not afford mortgage payments. These defaults also signaled the end of the US housing boom. US house prices started to fall and this caused more mortgage problems. For example, people with 100% mortgages now faced negative equity (Mortgage Guide). It also meant that the loans were no longer secured. If people did default, the bank couldn't guarantee to recoup the initial loan. The number of defaults caused many medium sized US mortgage companies to go bankrupt. However, the losses weren't confined to mortgage lenders, many banks also lost billions of pounds in the bad mortgage debt they had bought off US mortgage companies. Banks had to write off large losses and this made them reluctant to make any further lending, especially in the now dangerous subprime sector (Shah). The result was that all around the world, it became very difficult to raise funds and borrow money. The cost of interbank lending had increased significantly. Often it was very difficult to borrow any money at all. This affected many firms who had been exposed to the subprime lending. It also affected a wide variety of firms who now have difficulty borrowing money (Shah). The slowdown in borrowing has contributed to a slowing economy with the possibility of recession in the US and all around the world. Credit Crunch in the UK UK mortgage lenders did not lend so many bad mortgages. Although mortgage lending became more relaxed in the past few years, it still had more controls in place than the US. However, it caused very serious problems for Northern Rock. Northern rock had a high percentage of risky loans, but, also had the highest percentage of loans financed through reselling in the capital markets. When the subprime crisis hit, Northern Rock could no longer raise enough funds in the usual capital market. It was left with a shortfall and eventually had to make the humiliating step to asking the Bank of England for emergency funds. Because the Bank asked for emergency funds, this caused its customers to worry and start to withdraw savings (even though savings weren't directly affected). (BBC) As a result of the credit crunch, the UK saw a change in the mortgage market. Mortgages became more expensive. UK Banks continue to face problems too. HBOS (Owner of Halifax) struggled to finance its balance sheet. Like Northern Rock, it financed an expansion of lending by borrowing. Now money markets have frozen up, they couldn't raise enough money to maintain liquidity. (BBC) Now that mortgages are difficult to get, demand for houses has slumped. Therefore, house prices have fallen. Lower house prices mean many face negative equity. Therefore, mortgage defaults now cost banks even more (because they couldn't get back the initial loan). Bradford & Bingley was nationalised because it couldn't raise enough finance. The B&B had specialised in buy to let loans, which are particularly susceptible to falling house prices. (BBC; Mortgage Guide) What are the reasons for the money crisis The roots of the credit crisis stretch back to another notable boom-and-bust: the tech bubble of the late 1990's. When the stock market began a steep decline in 2000 and the nation slipped into recession the next year, the Federal Reserve sharply lowered interest rates to limit the economic damage. (William Bonner) Lower interest rates make mortgage payments cheaper, and demand for homes began to rise, sending prices up. In addition, millions of homeowners took advantage of the rate drop to refinance their existing mortgages. As the industry ramped up, the quality of the mortgages went down. (William Bonner; Economics Help) And turn sour they did, when home buyers had to leverage themselves to the hilt to make a purchase. Default and delinquency rates began to rise in 2006, but the pace of lending did not slow. Banks and other investors had devised a plethora of complex financial instruments to slice up and resell the mortgage-backed securities and to hedge against any risks - or so they thought. (Shah) Where did it first occur in the world The first shoe to drop wasthe collapse in June 2007 of two hedge fundsowned byBear Stearnsthat had invested heavily in the subprime market. As the year went on, more banks found that securities they thought were safe were tainted with what came to be called toxic mortgages. At the same time, the rising number of foreclosures helped speed the fall of housing prices, and the number of prime mortgages in default began to increase. (BBC) The Federal Reserve took unprecedented steps to bolster Wall Street. But still the losses mounted, and in March 2008 the Fed staved off a Bear Stearns bankruptcy by assuming $30 billion in liabilities and engineering a sale to JPMorgan Chasefor a price that was less than the worth of Bear's Manhattan skyscraper (BBC). In August, government officials began to become concerned as the stock prices ofFannie MaeandFreddie Mac, government-sponsored entities that were linchpins of the housing market, slid sharply. On Sept. 7, the Treasury Department announced it was taking them over. (BBC) Events began to move even faster. On Sept. 12, top government and finance officialsgathered for talks to fend off bankruptcy for Lehman Brothers. The talks broke down, and the government refused to step in and salvage Lehman as it had for Bear. Lehman's failure sent shock waves through the global banking system, as becameincreasingly clearin the following weeks. Merrill Lynch, which had not been previously thought to be in danger,sold itself to the Bank of Americato avoid a similar fate. (BBC) On Sept. 16,American International Group, an insurance giant on the verge of failure because of its exposure to exotic securities known ascredit default swaps, wasbailed out by the Fedin an $85 billion deal. Stocks dropped anyway, falling nearly 500 points. (BBC) What is the solution for this crisis This money crisis could last a long time because of the following reasons: 1. House prices are still falling in the US, reducing the value of mortgage loans 2. Many homeowners will still face rising interest rates, when their introductory periods come to an end 3. It can be difficult to regain confidence in the financial markets 4. A recession in the US and global downturn could cause a further rise in bad loans Most economic regions are now facing recession, or are in it. This includes the US, the Euro zone, and many others. At such times governments attempt to stimulate the economy. Standard macroeconomic policy includes policies to increase borrowing, reduce interest rates, reduce taxes and spend on public works such as infrastructure (Economics Help). Borrowing at a time of recession seems risky, but the idea is that this should be complimented with paying back during times of growth. (Economics Help) Likewise, reducing interest rates sounds like there would be less incentive for people to save money, when banks need to build up their capital reserves. However, as the real economy starts to feel the pinch, reduced interest rates is an attempt to encourage people to take part in the economy. (Economics Help) Tax reduction is something that most people favor, and yet during times of economic downturn it would seem that a reduction in tax would result in reduced government revenues just when they need it and then spending on health, education, etc, would be at risk. However, because higher taxes during downturns mean more hardship for more people, increased borrowing is supposed to offset the reduction in taxes, hopefully affording people a better chance to weather the economic storm. (Economics Help) Finally it is at this time that public infrastructure work, which can potentially employ many, many people, is palatable. Often, under free market ideals, government involvement in such activities is supposed to be minimal. Even the other forms of "interference" is usually frowned upon. However, most states realize that markets are not always able to function on their own (the current financial crisis, starting in the US, being the prime example); pragmatic and sensible adoption of market systems means governments can guide development and progress as required. (Economics Help) Nonetheless, many governments have started to contemplate these kinds of measures. For example,South Korea reduced its interest rates, as hasJapan,China,England, various European countries, and many others. Many have looked to borrow billions or in some way come up with stimulus packages to try and kick-start ailing economies. (BBC) While these might be reasonably standard things to do, it requires that during economic good times, a reversal of some of these policies are required; interest rates may need to increase (one reason for the housing booms in the US, UK and elsewhere was that interest rates were too low during good times), borrowing should be reduced and debts should start to be repaid, infrastructure investments may not need to be as direct from government and private enterprise may be able to contribute, and most politically sensitive of all, taxes should increase again to offset the reduction in borrowing. (Economics Help) Each of these measures should no doubt come under scrutiny from opposition parties and the media, to ensure they are appropriate, but some, such as tax hikes during good times can be so politically sensitive, that governments may be afraid to make such choices, thus making economic policies during bad times even riskier as a result. (Economics Help) Even then, the severity of these economic problems means that these strategies are not guaranteed to work, or it may take even longer to take effect. For example, more and more companies are announcing losses, closures, layoffs or other problems; people are becoming very nervous about the economy and spending less. (Economics Help) The automobile industry in the US, for example, is feeling immense pressure with some of the largest companies in the world facing huge problems and is asking the government for some kind of bailout or assistance. Yet, the US public generally seems against this, having already bailed out the banks with enormous sums of money (BBC). If the automobile industry is bailed out, then other industries will all cry for more money; when would it stop It may be that this time round a more fundamental set of measures needs to be considered, possibly global in scope. The very core of the global financial system is something many are now turning their attention to. Works Cited "BBC." 13 January 2009 . Economics Help. 23 September 2008. 13 January 2009 . Mortgage Guide. 12 March 2008. 13 January 2009 . Shah, Anup. "Global Issues." 3 January 2009. 13 January 2009 . William Bonner, Addison Wiggin. Empire of Debt: the Rise of an Epic Financial Crisis. James Wiley & Sons Inc., 2006. Read More