There are many opinions on the causes and subsequently the solutions for the current financial crisis. It is a global problem which threatens many major companies and banks, many which have all ready become bankrupt. The crisis is rising to its peak and can only be solved when the root of the problem has been addressed correctly by the government. This crisis is said to be the worst one since the Great Depression back in the 1930’s.
Cause
The Monetary Policy and the Housing Bubble
The crisis began at the beginning of the decade when the housing bubble began to grow. The low standards for borrowing money meant that more people were able to borrow money. Low interest rates are also a contributing factor to the increased amount of money lend to people. Alan Greenspan, the former chairman of the U.S. Reserve Bank was criticised for keeping the interest rates so low for so long. Interest rates during 2003 went as close to 0%. Greenspan believed in Self Policing (banks regulating their own loans) and free market and opposed financial supervision by the government.
The easy credit and low interest rates encouraged more people to borrow money to buy houses. This eventually created a national housing bubble. The increase in demand caused house prices to slowly rise until it became unaffordable for the average household. House prices had been rising at an annual rate of at least 10% for a number of years. The housing bubble peaked and burst in the year 2006 and after that, house prices started tumbling.
Subprime Mortgage Crisis and the Credit Crunch
But how did the housing bubble burst? Subprime mortgages are the culprit. The Subprime Mortgage Crisis originates from the risky loans made by lenders to people who do not have a stable income or no income at all. In the past decade, checks on a person’s credit history before lending them money wasn’t very strict, so borrowing money would have been very easy. It wasn’t until Lehman Brothers Holdings became bankrupt earlier this year (see below) that banks put stricter standards for lending money.
When banks lend money to people to buy houses, they either keep the mortgages themselves or sell it on in the secondary market. The major secondary market investors are Fannie Mae (FNMA) and Freddie Mac (FHLMC). The objective of these two companies is to constantly provide funds for the banks by buying mortgages which replenishes their funds so they can lend money to more people. But when banks lend money to homebuyers who cannot afford their mortgages (subprime borrowers), they put themselves at great risk if they keep the loans themselves. Because the checks on a person’s credit history wasn’t very strict, interest rates were low and the government encouraged people to buy houses, banks had not yet realised the risks of these loans. But these time bombs end up in the hands of FNMA and FHLMC when they unknowingly buy the bad mortgages (as well as good ones) off the loaner to replenish their funds. It’s found that FNMA and FHLMC owned $1.4 trillion or 40% of all American mortgages in which $168 billion were subprime mortgages.
Most of the time, the mortgages bought by FNMA and FHLMC are packed and sold as an investment product (e.g. a bond) to other investors (the public, businesses or even governments from other countries). Investors who end up buying the product made from a bad loan could end up losing a lot of money.
When some of the original homebuyers’ loans started defaulting because they had not enough income to pay their mortgages and banks began repossessing houses, the companies FNMA and FHLMC lose their income and therefore cannot pay what they owe their investors. Currently unable to pay investors or buy any new loans, the situation is the root cause of the Credit Crunch. As said above, banks become more cautious, money becomes a lot harder to borrow and there is less cash flow within the economy.
When banks stop borrowing money, less people are able to loan money to buy houses. Banks begin to repossess more and more houses causing house prices to fall (which is what’s happening now). As a result of house prices falling, people who anticipated buying a house lose confidence in the housing market because they’re afraid of falling into negative equity (paying more than your house’s current market value).
Who is to Blame?
Placing the blame can be very difficult in this situation. Are banks to blame because they were making irresponsible loans and selling them on the secondary market? Was the government to blame for keeping interest rates too low which caused the banks to make subprime mortgages? Or were the subprime borrowers themselves to blame? It is in fact all these factors combined that helped develop the current financial crisis.
For example, if the reserve bank didn’t keep interest rates so low for so long, less people would want to borrow money from banks to invest in the real estate market. There would be less subprime mortgages/bad loans and maybe the housing bubble may have never happened. But even if interest rates were kept very low, if the banks had been more responsible and made stricter checks on a person’s credit history before anything bad had happened, their would also be a lot less subprime mortgages and the financial crisis would not have followed. The current chairman of the United States House Committee on Oversight and Government Reform, Henry Waxman said that Alan Greenspan had the power to prevent what ended up as the subprime mortgage crisis by increasing the interest rates.
But not many people in the world can predict and confirm crises like this. Nouriel Roubini, a professor of economics at the University of New York predicted the coming of a financial crisis back in 2005. The following year, he announced in front of an audience of economists that there was going to be a severe recession. He said homeowners would start defaulting, and companies like Fannie Mae and Freddie Mac could be in a lot of trouble. His predictions were taken as a joke as the US economy then was still growing, though at a slower pace and Alan Greenspan’s monetary policy was still succeeding.
Effects
The crisis built up over a period of about a decade with the problem slowly accumulating over the time. When the problems start showing themselves, they never end. The effects are worldwide (see ‘Globalisation’) and many say the worst is yet to come…
Recession
Many countries in the world have gone into recession as a result of the global financial crisis. Some of these countries include: America, Japan, Germany, the Eurozone countries (for the first time in history) and the government of Iceland is already registered as bankrupt. France has narrowly scraped recession and Australia is also on the verge of recession. The bank of England stated that the world’s financial firms have lost around $2.8 trillion dollars in this crisis.
Debt and Bankruptcy
Bankruptcy cases today have increased by record numbers. In the past five months, bankruptcy cases in Australia have increased by around 13%. The government of America has a national debt of over $4 trillion dollars and investment analyst Marc Faber predicts that the U.S. government will bankrupt in a matter of time.
Lehman Brothers, a global financial services firm with over 150 years of history declared bankruptcy on September 14th 2008.
Currently, the Big Three motor industries Chrysler, General Motors and Ford are facing bankruptcy and are pleading the government to provide $25 billion dollars to save them. Their number of sales per annum has been reduced by almost half every year because of the lack of loans from banks to potential car buyers.
Fannie Mae and Freddie Mac are currently facing bankruptcy and will become bankrupt if the government doesn’t take action to save them. The government cannot allow the two massive companies to bankrupt because they take up too much of the housing market. If they do, the U.S. economy will suffer a big loss and the whole financial system will fall apart.
Citigroup, a worldwide bank even larger and older than Lehman brothers is also facing bankruptcy. Like Fannie Mae and Freddie Mac, the government cannot afford to let them fail because it will have a negative effect globally. The government has already agreed to inject $20 billion dollars into the company. Although, Bernie Sanders, a senator from Vermont believes in his statement that ‘A company that is too big to fail is too big to exist’ and the government should purposely let a major company fail to send the message to others in the future that no-body is going to save you from your own reckless behaviour. He believes it will help prevent a similar crisis from happening in the future.
Unemployment
Unemployment rates are increasing all over the world due to an increase of redundancies. The credit crunch suppresses companies from functioning and cash flow in the economy stops. Companies layoff people because they have no further need for them or cannot afford to keep them employed. As unemployment rates increase, so does the severity of the crisis. The U.S. economy depends on households consuming. When more and more people become unemployed, there is less money spent and so you get what’s called positive feedback.
· On May 6th 2008, Swiss bank declared that it would layoff 5 500 people by the middle of 2009
· Oxford economics is predicting that in London alone, 194 000 jobs will be lost in the next two years
· The Big Three have shed tens of thousands of people from their workforce in the last decade
· 1.2 million Jobs have been lost this year
Globalisation
Globalisation is the process in which the crisis spreads from one country to the rest of the world. The countries majorly affected by America’s economy breakdown are: China, Japan and Australia. China’s economy largely depends on exports to America and in return, China buys government bonds from America to replenish their funds. This relationship between America and China is a one way benefit for China because the American economy is constantly losing money. America has the same relationship with Japan. The governments of China and Japan are also the largest foreign holders of Fannie Mae and Freddie Mac bonds.
The next country in the chain is Australia. Australia’s economy largely depends on mineral exports to China for them to manufacture products. The high demand for minerals caused the mineral boom in Australia in the early 2000’s. When America stops importing from China, the growth of their economy slows down and they have no further need for new minerals. They stop importing minerals from Australia resulting in the end of out mineral boom.
Solution
Currently, there is no step by step solution to the crisis. Opinions on how to solve the crisis vary from the government taking major action in saving companies to leaving the market to correct itself. Only time will tell whose solutions to the problem will be right or wrong.
Government intervention
The U.S. government has already taken action to battle the financial crisis. The Bush administration has passed the $700 billion bail plan to save banks from collapsing. Different economists have different views on how the bail out should be used. George Soros, one of the greatest investors of his time believes that the bail out plan should be used to fix the mortgage crisis by re-capitalising banks instead of the original plan to buy bad mortgages off banks. The bail out will also be used to save
Soros believes that solving the mortgage crisis is first priority and to do that we need to slow the decline of house prices. His solution is to decrease the amount of foreclosures (repossessions by banks because of the borrower’s loan defaulting) by having banks negotiate mortgages with people instead of repossessing houses. If banks stop foreclosing houses, it will mean their will are less houses on the market and banks will not be so desperate trying to sell the houses again at lower prices.
Future president Barack Obama proposes to create 2.5 million new jobs by 2011. The jobs will create income for households and hopefully encourage more spending in the economy. The jobs will be created through establishing new projects like rebuilding roads and bridges, or investing into building alternate energy plants. These projects not only benefit the crisis, but it also benefits the economy in the long run. Investing in alternate energy is the first step towards diverging the economy’s reliance on foreign oil.
No Government intervention
However, Bernie Sanders is not in favour of the bail out plan. The money for the bail out comes from the hard working middle class people. He believes using their money to save banks from their own reckless actions is unjustified and that the money for the bail out should come from the people who have benefited from the banks’ reckless behaviour. Bernie Sanders is not alone in the argument against the bail out. Economist Jeffrey Miron believes that passing the bail out plan was the wrong decision and bankruptcy is the right solution to the crisis. Having companies bankrupt will take away the ones that have been careless with their lending and preserve the more responsible ones. Without the companies who would make risky loans in the future, there will be a lower chance of having another crisis.
Nouriel Roubini believes that it is impossible for the U.S. government to fix the financial crisis. He says that government intervention is necessary only for political reasons. With $4 trillion dollars of debt themselves, saving the economy from collapse will be just about impossible.
Similarly to Roubini, Marc Faber also has a pessimistic view on the bail out plan. He says, “A bailout will not buy the US a way out. The government is less powerful than markets in fixing this mess.” Compared with the dozens of trillions of dollars on the market, 700 billion is just too insignificant to do anything.
Conclusion
This financial crisis was caused by many factors put together. The irresponsibility of banks and the failure of Alan Greenspan’s monetary policy resulted in the worst recession after the Great Depression. The crisis is affecting the whole world with more and more countries going into recession. It will take a long time for countries to recover and governments are desperately trying to prevent any more losses of money. The solution to the crisis is debatable and nobody knows which is correct. We need to find a different way of regulating our economies to prevent a similar, if not worse financial crisis from happening in the future.
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