Causes Of Global Financial Crisis In The USA

The Role of Subprime Mortgages

Question:

Discuss About The Causes Global Financial Crisis In The USA?

The global financial crises origination was from the USA economy. This is the greatest recession that resulted in negative harmful impacts to many world economies. Some economies are still on the recovery process as the impacts still last to date. This paper will show the factors that contributed to the USA financial crisis which consequently resulted in the global financial crisis. The crisis can be argued to have been spread in a fast pace to the other world economies owing to the interrelatedness that has been raised by globalization (Rosner, 2013). There are a wide view of factors that major analysts has put forward to explain the causes. The major cause is argued to be the failure of the subprime mortgages that the mortgage lenders had introduced. According to Fisher (2013), there was a notable boom in the US housing market that later turned to be a painful burst.

It was in the mid-2000s when the housing demand in the US started rising; the rise was facilitated by factors such as; the mortgage interest rate was relatively low, there was a recovery of personal income, in addition, the credit lending standards were lowered. These factors made it easier for the households to acquire mortgage credits. The banks also went forward and started lending to high-risk borrowers whose incomes were too low. There was an increased housing demand which caused a rise in prices. According to Fisher (2013), the gauge for the US housing market by the Federal Housing Finance Agency’s (FHFA) showed that the price rose by 67% in 2007.  The low lending standards by the lending institutions is an indicator that there was limited government regulation. The recession triggered the attempt of many responses of which some were deemed successful whereas others did not result in significant changes.

Most economists consider the actions of the US big banks to be the real origination of the global recession; there is a great support for the same. This paper will cover the performance of the US economy prior and during the crisis. The factors that contributed to the global recession will be determined whether they started showing up signs on the same year of the crisis or had shown signs for a period before. If we find out that the signs had been shown a long time before, we shall conclude that the crisis was avoidable. However, if the signs showed up closer to the crisis, it will concluded to have been unavoidable. It shall put more emphasis on the major factors that are commonly agreeable to have been behind the global recession. We shall analyze where the banks went wrong and also where the government failed to play its part well.

Involvement of the US Government

The US housing boom was stimulated by the deep involvement of the US government on its mortgage market through various regulations. Its main aim for the deep involvement was to facilitate the access of credit to the subprime borrowers. For instance, the 1977 Community Reinvestment Act prohibited the discrimination of borrowers based on their income levels. The 2003 American Dream Down payment Assistance Act provided closing cost assistance and down payments to low-income communities (Malinen, 2017).

The turmoil in the US financial market lasted from 2007 to 2009; it was caused by a housing bubble that was as a consequence of the expansion of mortgage loans to borrowers that were of high risk. Initially, the interest rate were very high and the potential borrowers were discouraged from borrowing from the lenders because servicing the debt was more expensive. When the interest rates were lowered by the federal government, the servicing costs fell and mortgages became less expensive to the borrowers, it attracted many less risk and high risk borrowers (Amadeo, 2017). Initially, the high risk borrowers wouldn’t be allowed an access to credit; the lenders were of strict restrictions. The only people who were allowed access to mortgage were those who had credit histories that were above average. The purchase for homes was thus low since many people had credit histories that were below average. Their requests for small down payments or on choosing high payment loans were always denied by the lenders unless they were backed up by the government insurance. The Federal Housing Administration (FHA) backed some high-risk families to enable them to acquire access to small-sized mortgages from the lenders. Those who were not backed up by this government’s body were forced to depend on rentals. The stemming of the 2007-10 subprime mortgage was from the expansion of mortgage credit to even the high-risk borrowers. Since people had more mortgage credit, their demand for homes went up consequently resulting in rising home prices (Anderson, 2017). The availability of mortgage credit to those who couldn’t access them before contributed to a fluctuation in the homeownership by around 65% with low mortgage foreclosure rates.

It was in the mid-2000s when the lenders made a decision to make credit mortgages available to the high- risk borrowers through selling them to investors while repackaged into pools.  These risks were apportioned by the use of new financial products; most of the subprime mortgage funding was now provided by private-label mortgage–backed securities (PMBS) (Duca, 2013). The new financial instruments used made the securities to be viewed as less risky. More potential first-time homebuyers were attracted to the mortgage credit and thus a rise in the homeownership (He, Jun and Strahan, 2011). The supply of houses is not equal in all the places; there are places where it’s high and others where it is too low. The credit expansion raised the demand and thus home prices went up; the rise was so intense in areas where the supply was already insufficient. The houses were projected to continue gaining in value as their demand and prices continued rising. The investors were protected from making losses since the house prices were on the rise and thus purchasing of the PMBS was at first profitable. It reached a point when the high-risk borrowers were unable to make their repayment obligations and were thus forced to sell their homes at a higher gain and repaid their mortgages obligations, otherwise, the made some additional borrowing against the higher market prices and continued with their repayments. The sustainability of the new mortgage product (PMBS) was untested and thus its riskiness was unknown.

New Financial Products and Homeownership Fluctuations

When the peak for house prices was reached it became less viable for settling mortgage debt through re-borrowing by the investors to refinance the mortgage or even selling the homes. This resulted in a rise in the mortgage loss rates for both the lender and the investors. Stateofworkingamerica.org (2017) noted that the 8 Trillion burst of the housing bubble was the beginning of the financial crisis in the US. Consumers’ spending was reduced since there was a great loss of wealth in the economy. When the bubble busted, there were chaos triggered on the financial markets; these chaos combined with the decreased consumer spending distorted the business investment (there was a collapse) as shown below.

The trust in business in the US before the crisis was higher compared to the other economies. During the crisis the trust fell by a 20-point drop. The drying up of business investment and the consumer spending resulted in a massive loss of jobs. The New Century Financial Corp was the first leading lender of subprime mortgage to file for bankruptcy in April 2007. Shortly thereafter, the initially viewed as of low risk PMBS and their backed securities were then downgraded to high risk; several subprime lenders ended up closing down. This resulted in a collapse of the subprime bond funding which consequently prevented the lenders from not only making additional subprime mortgages, but also avoided the nonprime mortgages. The unavailability of mortgage credit resulted in a falling housing demand and thus a decline in the house prices (Kolb, 2010). Further expectation of a falling price completely made the demand to shrink. The decline in prices was so extreme such that it became so difficult for the high-risk borrowers to repay their mortgages; even after reselling their homes, the money received was inadequate to fully repay their mortgages. This was not only to the high-risky borrowers, but also to the less risk borrowers who had initially provided high-sized down payments.

Fannie Mae and Freddie Mac were government-sponsored enterprises that made huge losses as a result of the failing prime mortgages; this forces the government to seize them in the 2008 summer. The reason for the government to lower its interest rate was to boost the ownership of homes. This federally mandated goals made Fannie Mae and Freddie Mac to issue debt for funding the purchase of the mortgage-backed subprime securities whose value fell after the default rate by the borrowers increased (Atif, Sufi and Trebbi, 2010); their action was according to the 1992 Housing and Community Development Act. These two enterprises suffered great losses after the prime mortgage failure; they had bought the backed securities, insured them, and bundled them into the investors’ package of prime mortgage-backed securities. The losses made by the subprime lenders, the falling into bankruptcy and the closure of some lenders resulted in increased restriction on credit advances to both the high-risk and the low-risk borrowers; the qualification for such loans was made to be more difficult resulting in an extended fall in the housing demand.

Collapse of Subprime Lenders and Housing Market Decline

The housing market became weak as the number of repossessions multiplied as a result of increased foreclosures; many initial investors sold their homes at lower market prices. Some delinquent borrowers also tried to sell their homes in an attempt to avoid the foreclosure (Friedman, 2011). The selling sometimes was on short sale where lenders accepted partial losses for homes sold at a value lower than the owed amount. The bursting of the housing bubble that caused the 2007-09 recession affected the overall economy in several major ways. Construction was lowered, consumer spending was lowered since their wealth was reduced, the lending ability of firms was reduced and the firm’s ability to raise funds from securities market was also reduced (Duca, 2013).

This is another factor argued to be responsible for the financial crisis in the US. It is noted by Malinen (2017) that before the crisis, the US had left its monetary policy to remain so loose. This is also a factor that contributed to the housing boom that later resulted in the worst burst ever. The loose monetary policy raised the circulation of money into the economy and raised the demand for assets (Taylor, 2014). It was left to be loose so as to stimulate the economic performance of the US economy.

Conclusion

The US economy is actually the real origination of the 2008-09 global recession. The financial crisis was caused by regulatory poor regulations that were aimed at promoting the US economic growth. There are many policies that were used in an attempt to attain recovery in the US and all other affected economies. The global recession was a good basis in which world economies can determine the signs of the occurrence of a recession and bearing the fact that recovery from this global recession was an extended process, they will employ policies immediately in order to avoid it. During the housing bubble boom that resulted from expanded subprime mortgage, the house prices rose to very high levels, however, the failure of the prime mortgages resulted in an accelerated downward spiral on the home prices. The fact that the signs for the US financial crisis were in existence long before the crisis, it can be concluded that the crisis was avoidable. The government can therefore be accused for poor financial regulations.

References

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