It is believed that after 1930, the biggest financial crisis began in the summer of 2007. The crisis started on August 9, 2007, when a number of financial institutions announced they intended to terminate their short-term loans.[i] It started in the real estate market of the USA, and then it spread over other domains and countries through domino effect. There are disagreements among the economists about the causes of the crisis, so only the main causes and factors will be presented in the work.
In order to analyze and understand the decline in the financial sector, the financial and economic crisis and the global economy’s weakening, first of all it is necessary to return to the past and to look at the US history. The policy pursued by the US government, financial market structure, real estate market developments on one hand, failed macroeconomic regulation and the greed of Wall Street bankers and investment companies on the other hand, led to such catastrophic consequences. Now let’s look at these factors separately.
- US Government’s Economic Policy
After the Second World War, the US government began to undertake measures to restore, rebuild and revitalize the national economy. Among these measures, the construction of new residential areas can be separated. To that end, the US Government invested a mortgage lending system that were used in England before. For a mortgage loan, a certain prepayment (usually within 3-20%) or mortgage partial insurance was required. Employment and income certificates were minimal requirements for obtaining a loan. It should be noted that at the initial stage this kind of loan was intended only for beneficiaries of the main market, that is, those who satisfied the strict requirements set by banks for lending. Hence, since 1992s, the US government has developed a new policy related to providing housing to US middle class residents. To that end, the National Bank of America, the Federal Reserve, lowered the interest rate to 1% within 2001-2004, allowing banks to lend in more lenient conditions. This step was also aimed at promoting economic growth and development, as well as creating new vacancies. Due to low interest rates, the demand for mortgage loans grew significantly since more and more citizens have been able to afford housing on such terms.
Growing demand, in its turn, led to the increase in housing prices in the real estate market. US banks and individual investors began using this opportunity to raise prices in order to earn large sums in the real estate market. Because the interest rates were low, it was profitable for banks to borrow loans for 1% from the Federal Reserve and direct that sum to mortgage lending. In literature, this is considered as the beginning of the financial decline.
To understand the US Government’s policy, see Figure 1, which presents the US population’s housing coverage during three decades.
As it is seen from the schedule, within 1992-2004 the implemented expansionary policy has provided some positive trends, a steady increase in the index. If in 1992 63.9% of the US population was provided with housing, then in 2004 this figure was 69.2%. As a result of the onset of the crisis started in 2006, it has consistently showed decreasing trends in 2016 registering the lowest result of that period – 62.9%.
Figure 1. Housing coverage level in the US, 1982-2016[ii]
- US Real Estate Market Crisis or Housing Bubble
The profitability of mortgage lending was gradually rising, and the US banks began to sell these loans as assets, and to re-direct the sums to mortgage lending. Mortgage Backed Securities (MBS) were created on the basis of sold loans, which were sold to other banks, investment funds and investors both in the United States and around the world. This means that when the owners of flats make periodic repayments on their loan, banks keep a certain amount of commissions from that amount and transfer the remaining amount to the acquired MBS companies, and the latter to the final investors. Due to the rise in prices in the housing market in that period, MBSs were considered a fairly safe option, so banks and other investors, including pension funds, began investing in these securities.
Sometime later, the number of people who could afford to borrow a mortgage under these conditions and the banks began to look up new options for promoting the population’s demand. To that end, they started providing new mortgage loans (Subprime Morgages), which, unlike the previous ones, did not require data on employment and income. This allowed the US lower middle-class population to use the loan. Additionally, under new conditions, citizens could borrow more money than the appraisal or market value of the apartment.
Against the backdrop of the rise in housing prices, many buyers purchased these apartments not for living but after a while to sell at higher prices.
In 2006 the level of housing prices has reached its peak level, after which there have been signs of decline in individual indicators. In order to regulate such pressures, to curb the ever-increasing demand the Federal Reserve had been continually increasing the rate of interest by implementing a restraining monetary policy since June, 2004 / Figure 2 /. At first it did not give the expected results. Nevertheless, within July, 2006- June, 2007, relative stabilization was observed in June, as a result of which interest rates remained at the level of 5.25% during that period.
As a result of the increase in interest rates, those whose loan interest rates floated were now forced to pay more interest, unlike fixed interest rate borrowers, with interest rates fluctuating in the market in no way affecting their interest rates.
Figure 2. The effective interest rate of US Federal Funds, 1988-2016
This and a number of other factors /e.g. increase in subprime interest rates on borrowers’ insolvency/ resulted in an increase in non-repayment of loans. As a result, these apartments became the property of banks and investors who issued or purchased MBSs. And as the prices of apartments in that period still remained high, banks and investors began to sell them. After a while, the offer of housing began to exceed the demand, which immediately led to the reduction of prices. The further course of events can be explained by the “domino effect”. Fearing further fall of prices, owners, banks, and other investors began to get rid of their apartments until they lost even more money. As a result, the US real estate market fell.
After June, 2007, when the prices for apartments began to decline, the Federal Reserve again started implementing an interest rate reduction policy, leading to a decrease in other interest rates on the market /Federal Funds interest rate of 2009 reduced from 5.25 percent /2007/ to 0.15 percent.
3.The weak control of the US financial system
In the 2000s, the US financial market, including the derivative market, was characterized by weakness of the state regulation, sometimes even lacking. This allowed the financial market participants to develop and introduce new financial instruments in derivative securities that had speculative nature and varying degrees of risk. In general, the purpose of derivative financial instruments was to insure investors and other participants of the financial market from different risks. But later, due to their high yields, they were used mainly for speculative purposes.
This also was contributed by the fact that unlike real assets, derivatives were traded with a fairly small amount of transactions. All this has led to the fact that in just three decades the volume of transactions with financial derivatives has grown more than 300 times. And already in 2008, October, the US Over the Counter non-regulated derivative market totaled $ 600 trillion.[iii]
Among derivative financial instruments, Collateralized Debt Obligations (CDOs), which were issued by investment banks, can be distinguished. The latter collect various debt liabilities and group them in three tranches[iv]. Suitable CDOs are issued for each tranche. Then banks apply to rating agencies to assess their CDO risk and profitability. These tools allow you to meet a variety of needs, as investors in financial markets have different preference for risk and profitability. It should be noted that investors prefer the first between CDOs and individual debt badges, because in this case derivative securities minimize investment risk through diversifying. That is, if he is damaged by a liability /asset/, then that loss can be compensated or at least mitigated by the incomes of other liabilities. In addition, CDOs, as a security, have higher liquidity.
As a result, the demand for CDOs grew so much that their circulation crossed the state borders. The relationship between creditors and new lenders further complicated the situation in the financial market.
- The role of US investment banks, CDOs and rating agencies
The US banking and investment sectors have a long history of activity and have always played an important role in the development of the US economy. The two spheres, being specific, had at the same time certain aspects of functional distribution, which, however, contained additional risks. That is why in 1933, The Glass-Steagall Act was passed, which separated commercial and investment banking services. As a result of this differentiation, securities companies and investment banks could no longer accept deposits, and Federal Reserve member commercial banks were prohibited to engage in dealer activities (buying and selling corporate securities) for investors, investing in various securities, and placing securities[v]. In 1999, US President Bill Clinton publicly announced the revocation of this law. Many commentators consider this change one of the reasons for the crisis.
The development of investment banking started from the 80s of the 20th century. Over time, investment banks were grouped and gradually acquired monopoly status in the US financial market thanks to their mergers and acquisitions. The entire US industry was under the influence of five investment banks (Goldman Sachks, Lehmann Brothers, Morgan Stanley, Near Stearns, Merrill Lynch), three major insurance companies, including AIG and three major rating agencies (Standard & Poor’s, Moddy’s, Fitch).
Some experts believe that the world’s largest rating agencies and particularly the “Big Three” – Moody’s, Standard & Poor’s and Fitch,[vi] have exaggerated the US financial system, giving high ratings to companies and their issuers without properly assessing their risks, by promoting the circulation of financial derivatives, and the other part believes that the investors are guilty. We think that all the participants have their share of sin.
Investing profitability made investment banks to release more and more CDOs/ Collateralized Debt Obligation/. Unlike others, newly-issued securities had many high-risk loans and debt obligations characterized by high risk. In order to sell the listed securities, investment banks were paying investment banks were paying extra to rating agencies to give their CDO higher ratings. Strong competition between the three main agencies did not allow them to abandon this kind of deal because otherwise the other two agencies would do so. In addition, these deals were beneficial for both parties as they allowed to multiply their income several times.
- Role of the World’s Largest Insurance Company/AIG /
This company, among numerous insurance services, also carried out product insurance on the financial market. For example, in the case of CDOs, the mechanism was the following: an investor who acquired CDO would buy a certain amount of insurance and the insurance company would be obliged to compensate for the loss of the investor if the CDO payments had not been made. Unlike other insurance companies, AIG sells insurance policies not only to CDO owners, but also to various speculators who, in turn, easily resell them because there was no state regulation. As a result, when the borrowers ceased to fulfill their obligations, AIG became fully insolvent.
Taking into account that there are many possible reasons that have led to the recent financial crisis, we have touched upon the key elements of the work.
To summarize, it should be noted that in the history of the global economy many crises are known, which differ from their underlying causes, inclusion and duration. The problem is how each country faces the challenge or what steps it takes to minimize or neutralize the crisis. In this regard, first of all it is important to highlight the priorities of the state policy, to expose the potential of the given country, its existing resources and opportunities and to develop measures for their effective and purposeful use.
[i] John C. Hull «The Credit Crunch of 2007: What went wrong? Why? What lessons can be learned», Toronto, May 2009, http://www-2.rotman.utoronto.ca/~hull/DownloadablePublications/CreditCrunch.pdf
[ii] Economic Research Centor of Federal Reserve Bank of St. Louise, https://fred.stlouisfed.org/graph/?graph_id=423122
[iii] Barrett Sheridan., “The $600 Trillion Derivatives Market”, Newsweek, Oct. 18, 2008, http://www.newsweek.com/600-trillion-derivatives-market-92275
[v] Glass-Steagall Legislation, https://en.wikipedia.org/wiki/Glass%E2%80%93Steagall_legislation
Author: Nelly Zakaryan © All rights reserved.
Translator: Anna Arushanyan