Since the world economy became the market oriented and the mainstream production relationship was dominated by capitalism, the economy crisis was associated with the economic development. In fact, there is a long story to discuss what triggered the economy crisis or financial crisis. Keynes(1936) argued that the wave of animalism of human beings is the key factor to drive the business cycle and lead economy crisis. While some economists proposed other economic theories that aim to explain that puzzle. Even in these days, it is still a very hot topic to discuss the causes of economic/financial crisis. One of the most important reasons is that the world economy has not recovered from deep recession that happened since 2007/2008 financial crisis. At the moment, there is at least one point about this financial crisis that all people should know, which is the sub-prime housing market in the United States triggered the financial crisis. In latter part of this article, it will attempt to explain the mechanism of sub-prime housing market lead to financial crisis. Then, at last part, it aim to analyze who are to blame for the crisis or who is the ultimate source to lead this crisis.
In the first place, it is necessary to define what is sub prime housing market. According to U.S. Department of Housing and Urban Development, subprime loans are for persons with limited credibility or with highly default risk, the interest rate for that loan is higher than prime loan so that could make compensations for lenders who bear much risk than prime loan (http://portal.hud.gov/hudportal/HUD?src=/program_offices/fair_housing_equal_opp/lending/subprime). Then, the sub prime housing market is easy to understand, which means banks and other financial institutions made loans to people and help them to purchase residential houses in market, but those people had relatively low income and low credibility, which means they have to accept the higher interest rate charged by banks for their mortgage loans. While, it is interesting to learn how financial institutions collected monetary resources to originate sub prime loans. In fact, financial innovations, especially for creations of financial derivatives made significant contribution for the prosperity of sub prime housing market prior to crisis. They consist of mortgage-backed securities (MBS), credit default swap (CDS). Investors value MRS through the change of housing price and interest payment, it is the same as security, of which the fundamental value is based on dividend and net present value of share. CDS offers a kind of credit risk reduction mechanism, which means the holder of credit swap obtains compensation from seller of the swap in case of default (http://www.investopedia.com/terms/c/creditdefaultswap.asp#axzz1j9k4G8fq). It is reasonable to believe that the sub prime loans were preferred by investors, which is partly because the help of financial innovations. The other reasons are that the housing boom and credit ease prior to financial crisis, which could be the most important factors to boost the sub prime loans market.
It is necessary to make a clear picture to demonstrate the sub prime housing market and the relations with the whole financial market and macro economy. To make it simple, just assume the receiver of sub prime loans are poor people, the holders of sub prime loans are rich investors, financial institutions play a role to facilitate transactions between borrowers and lenders, buyers and sellers of sub prime loans. In fact, for many investors, they are not concerned about whether poor people are able to complete repayment schedules in future, but consider whether they could obtain profits in financial market at short time. Of course, when the housing price keep rising up, which means the value of mortgage-backed securities is rising up as well, poor people are definitely unable to purchase the house by themselves, but they do not need to worry too much thanks to sub prime loans. At the same time, investors and institutions are very happy to see the housing boom, not only the value of their own assets increase largely, but also the value of sub prime loans, which could be regarded as one particular opportunity to pursue profits. It seems that there is an optimistic scenario, which poor people got help from generous rich and achieve their “American dream”, rich also could enjoy huge benefits no matter in monetary or non monetary terms. As a result, the housing boom could be enhanced thanks to more money is poured into market, subsequently, the housing boom would boost the overall economic growth due to the aggregate demand increased largely. However, in this nearly perfect picture, there is only one thing that ignored, which is housing price could decrease.
Federal Housing Finance Agency provides the overall housing price appreciation index. In 2005 Q3, the index was about 10%, which is the peak point from 1998 Q3 to 2011 Q3. Then, the index was decreased dramatically until in 2008 Q3, which was the bottom point for that index (http://www.fhfa.gov/Default.aspx?Page=14). It is clear to identify that there was a housing bubble prior to 2007 and the burst of bubble is the direct factor to lead the financial crisis. Based on the discussions above, it is easy to imagine the reactions of investors, borrowers and financial institutions when they knew the housing price fell dramatically within a short time period. For poor people, once they noticed that the housing price decreased substantially, in their own opinions, the best response is to stop loan payment and just bring the key of house to bank. The reason is simple because the value of assets are much less than they purchased initially, which means if choose to live in their mortgaged house further, it means withdraw their own money, reduce their own wealth and send those to banks as a goodwill. Further, since poor people have obtained great utility that origin from becoming house owners, it would not make too much loss for them once leaving their mortgaged houses. However, for financial institutions, bankers, traders and investors, they should feel painful and produce much disutility. As an important financial asset, the value of sub prime loans became less and less. When they seized mortgaged houses from those poor people, they found that those real estates were less valuable and even cannot be used to pay back their own debts. In fact, the overall capital market cannot be free from housing bubble burst and related sub prime loans market failures. Of particular, the shadow banking systems and off balance sheet activities made situations become much more complexity. As a result, the collapse of sub prime loans market made significant losses for many participant parties in capital market, then, the overall market confidence is influenced by investors’ pessimism largely, which produced the similar scenario as Keynes argued, the pessimism spread out widely so that large number of investors decrease the volume of transaction or pulled money out of from market, even ordinary consumers decrease the general living expenses. As a consequence, the overall economic growth decreased significantly due to the decrease of aggregate demand. Then, the overall economic environment become worse off and the activities of enterprises or manufacturing industries slow down. The operating revenue and profit for them are necessary associated with the operating environment. In fact, this cycle effects are most likely to lead the recession or even depression.
It is very meaningful to identify what really caused the financial crisis. Are all blames should leave to those bankers? It is undisputable to believe that bankers are responsible for risk management failures, overconfidence to their financial innovations and lack of systematically or rational thinking. However, it is not reasonable to think that only bankers are responsible for this financial crisis. There are at least two sides that should be considered, one is the domestic and international regulatory framework, the other is government failure. Firstly, it is to talk about bankers’ failures or their responsibilities on financial crisis. As we know, the Wall Street influential are becoming greater and greater, one typical example is that despite huge losses and bailout by government, many employees in Wall Street collected $18.4 billion in bonuses in 2009 (http://www.nytimes.com/2009/01/29/business/29bonus.html), which was criticized by many parties, one of the best parables is that government extracted money from mass taxpayers and subsidized to financial elites in Wall Street. Similarly, Johnson (2009) argued that capturing by financial elites is important factor to cause the global financial crisis. In his article, which revealed an important relationship between Wall Street and Washington, he listed some important figures, such like Robert Rubin, Henry Paulson, John Snow and Alan Greenspan, all of them were used to be top officers in financial departments of government, and all of them were involved in governance of top financial institutions in Wall Street before or after their public positions. He even summarized that to be an investment banker is the pre condition to become a central bank governor.
However, although Mr. Jason made thesis point on demonstrating the powerful of Wall Street, but he might not explain questions such like why there are so many poor people cannot afford house with normal mortgage rate or why the Federal government intervened housing market and encouraged government agencies to do some specific programs to help poor people achieve their “American dream”? It is reasonable to think that income inequality is the core source to capture government attentions on taking some useful measures that aim to curb the problem and the housing program might be a suitable solution in short term. Rajan (2010) argued that income inequality is important factor to cause the GFC and guide some specific government policies. He pointed out that the 90th percentile of wage rate distribution grew much faster than median worker since 1970s. In fact, the technological progress cannot bring benefits to all kinds of workers. Of particular, for those workers with high skills, it boosted their earnings through creating more value added products, but for those only with low skills, they were beaten by cheap products or labor force that from developing countries. The phenomenon above is partly attributed by education system that cannot provide necessary training or education to mass labor force. Government recognized this serious issue, but it did not have many options when needs to consider election requirements. As a result, to take indirect subsidy policy with the help of Wall Street financial elites, government aims to satisfy both poor and rich so that winning more electorates. Although some policies might be shortsighted or potential harmful, but the election politics are always the most important issues for politicians to consider.
The last point is beyond the individual country’s management boundary. The lack of effective and efficient international regulatory framework should be partly blamed for the financial crisis. Atkinson et al. (2008) argued that financial crisis was arising from global macro liquidity policies and the poor regulatory framework. In detail, they summarized four specific factors that could raise the possibility of financial crisis. They are zero equity mortgage proposals in the Bush Administration; to provide more opportunities for banks to participate the sub prime loan market; the Basel II accord produced an arbitrage opportunity that encouraged banks to accelerate off balance sheet activity; to provide more favorable regulations to investment banking groups.
Keynes, John M. (1936). The General Theory of Employment, Interest and Money. London. Macmillan. pp. 161-162.
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