Running Head: SUBPRIME CRISIS 1

Size: px

Start display at page:

Download "Running Head: SUBPRIME CRISIS 1"

Frank Benson
5 years ago
Views:

1 Running Head: SUBPRIME CRISIS 1 Subprime Crisis Student s Name University

2 SUB-PRIME CRISIS 2 Introduction This essay examines the underlying causes of the sub-prime crisis and consequential crisis that wrecked global financial markets; and the various attempts to remedy the situation both domestic and supranational. A deeper analysis of the crisis reveals that disproportionate deregulation, low interests rates, housing bubble and bad lending were the main cause of the subprime crisis and the resultant global financial downturn. Regulatory authorities had become aloof of financial markets, believing that market participants were rational. Sub-prime lending losses kick started late 2007 in the US, exposing other risky loans and exaggerated asset prices. Singapore, like many other open economies, the spreading global crisis triggered a slowdown in key sections. Economic growth decelerated, unemployment and inflation rate rose, and the balance of payment shifted negatively leading to a decrease in reserves. The next section discuss in detail the causes of the sub-prime crisis. This will be followed by an analysis of the interventions and coordination, and a conclusion summarizing key findings. Causes of the Sub-Prime Crisis The US over-accommodative monetary policy left financial institutions with excess liquidity, nudging them to engage in imprudent behavior. Lenders took on massive subprime loans that ultimately that they were not able to service. The entire industry was gushing with greed, with everyone yearning for more and more (Brummer, 2008). Government-backed mortgage entities invested heavily in subprime and senior debt market, overlooking the high risks associated with these categories. There were warning signs raised regarding the susceptibility of prime loans to losses contingent on house prices. Also, there were concerns about the reliability of the credit ratings that seemed to support the activities of lenders and borrowers (Hagerty 2008). Nonetheless, no one seemed to heed to the call. With each every

3 in percentage SUB-PRIME CRISIS 3 increase in the availability of subprime credit, the crisis continued to deepen. There was a general increase in consumer s speculative consumption psyche for commodities that were beyond their disposable income. Consumerism, coupled with cheap credit exacerbated the likelihood of loan defaults, thus aggravating the credit crunch even further.the damaging partnership of real estate developers, banks and Government Sponsored Entities (GSEs) which has the full blessing of the US government home ownership policy was the oasis of the subprime crisis. The US government had envisaged increased homeownership bypromoting access to mortgages to many who could not afford buying homes. Special agencies in charge of disbursing subprime loans were not adequately scrutinized and subjected to regulations, leaving too much room for fraud and abuses such as predatory lending (Schumer and Maloney 2007) Fig-1: Federal Funds Rate Axis Title Federal Funds Rate Favorable lending terms were myopically premised on the assumption that house prices only appreciate in value. However, when the US government (after experiencing economic strain due to the war on Iraq and Afghanistan), tightened its monetary policy, pushing up the federal rate to 5.25% from 1% and imposing reserve requirements during (see fig-1), banks

4 SUB-PRIME CRISIS 4 were left strained. The burst cycle began as banks scale down loan issuance and property prices began to fall. There were For Sale signs everywhere as the panic-stricken real estate sector rushed to offload assets and cut losses. Banks holding real estate loans and stocks suffered greatly as houses nose-dived (Brummer 2008). It was inevitable that lenders could not recover their investment even by liquidating the assets given the low prices. The result was widespread defaults and retrenchments in key sectors, notably the financial system, exacerbating the problem of falling asset prices. Fig-2: Events leading up to the crisis Low interest rates Deregulation Increased Lending Banks rushed to expand subprime loans Borrowers madness and consumerism. Government contractionary monetary policy to cub inflation (low interest rates and reserve ratios). Banks scale-back lending Prices fall Market panic Property Burst Foreclosures Expansionary Monetary policy Inflation Loan (Ban In fig-2, the series of failures based on irrationality, information asymmetry and poor coordination. (Krugman, 2009).The unfolding of the events revealed that expansionary monetary policy and the bet on high asset prices, and subsequent plunge in asset prices (depicted as real estate boom and bust) are symbiotically connected. The Fed s expansionary monetary policy (low interest rates) contributed to the boom in the real estate sector (increased demand and

5 SUB-PRIME CRISIS 5 prices). Market overexcitements and lenders madness to issue loans without due diligence led to the boom in house prices. The activities leading up to the crisis can be summarized by fig-2. Policy Responses Global Interventions In response to the subprime crisis, the Federal Reserve acted quickly to increase shortterm liquidity and boost market confidence. While the measures were not very efficient, they helped to get the credit flowing in the economy to boost activity. One of the most important action was dealing with letters of credit to avert a systemic collapse of the global trade. Various countries and institutions like the European Central Bank (ECB) responded with stimulus packages to set-off stalled economies. The reactions were rather haphazard and uncoordinated, even with global summits such as the G20. As a result, some of the measures failed to achieve their intended targets. For example, in the US, stimulus packages were too small to boost aggregate demand because consumers chose to save the rebates rather than invest. Given the enduring problems, the US government resorted to controversial measures, such as quantitative easing, to deal with the crisis. For example, the Federal Reserve agreed to shoulder risks of financial institutions such as AIG and Bear Stearns by accepting mortgage-backed securities as collateral. The government also nationalized government-backed mortgage institutions by pumping in fresh capital. All these measures restored market confidence, though gradually, saving the financial markets from total collapse. Other Western governments also spent trillions of dollars to shore up their financial systems. The actions taken by developed countries were unprecedented, unconventional and extreme given that the damage inflicted by the crisis on financial systems was enormous. A combination of high stimulus packages, quantitative easing and accommodative monetary policies and austerity (in European economies)played a significant

6 SUB-PRIME CRISIS 6 role in saving the entire financial system that was on the brink of system collapse (Krugman, 2009). Singapore's response In Singapore, the financial system remained robust and promising throughout the crisis, partly due to lessons learned from the 1997 Asian Financial Crisis. There was no extreme damage to warrant government injection of stimulus packages into financial institutions. Banks were adequately capitalized and only held a small portion of non-performing loans on their balance sheets. In addition, the banks were less leveraged, with minimal currency and derivatives exposures and maturity mismatches. Nonetheless, this does not mean that Singapore was not affected in any way. In the period preceding the crisis, Singapore had enjoyed a period of surpluses. Given the intensity of the crisis that dented a blow on global aggregate demand, Singapore experienced decelerated growth due to decreased exports and local production and overall GDP (see fig-3). Fig-3: Singapore's GDP 400, , , , , , , , GDP at Current Market Prices Services Producing Industries Goods Producing Industries

7 SUB-PRIME CRISIS 7 As a result, the government withdrew about S$4.9 billion from its surpluses to expand its fiscal stimulus program. The benefits of the program were guaranteed economic growth, with expansions in both product and services sectors (fig-3). The intention was to help struggling local firms (due to low productivity) to sustain jobs and increase activity. The program was christened Resilience Package, focusing on preserving jobs and expanding credit through relations with banks under the Special Risk-Sharing Initiative (SRI). The measures were successful in preserving and improving business effectiveness and stabilizing employment (Kawai, 2010). The substantial reserves which were used for the first time came in handy, allowing Singapore to deploy quick short term measures decisively. With regards to regulation, Singapore s monetary authority, Monetary Authority of Singapore (MAS) picked up more lessons from the crisis by realizing the increasing global economic interrelatedness and how external factors spill-over systemically. By mitigating excessive build-up of market prices and credit, checking pro-cyclicality and cushioning the financial sector, subprime crises can be largely averted or contained when they occur. In retrospect, long term regulatory measures insured Singapore sfinancial sector, curbing any possibility of lender imprudence. MAS was also clairvoyant in taking into consideration that firms were likely to decrease production and make losses from falling demand and commodity prices. One outstanding rule was to compel banks to maintain 1 percent of their net loans and receivables to cater for impairment provisions. This created a collective buffer in the financial sector that was extended to firms during the crisis to stimulate economic activity (Mah-Hui& Chin, 2010).

8 SUB-PRIME CRISIS 8 Conclusion While subprime lending is not the mother of all evils, its misuse can have far reaching consequences on the global financial systems. The subprime crisis exposed a malady that was growing within the financial system for a couple of years. The combined actions taken by mortgage lenders and borrowers, rating agencies and irrationally exuberant investors (coupled with lack of proper regulation) led to the crisis. The increasing growth of subprime lending consequently crashed financial institutions, adversely affecting home owners, investors, and tax payers. In addition, ineffective and scrappy regulatory regime weakened the key foundation of market-based financial systems. The implications for policymakers show include the need to ensure accountability of financial entities, especially those with high potential of creating and spreading systemic risk. There is also need to improve global coordination and regulation of economic and business activities. The crisis showed that the state has a role to play in setting a fair and monitored playing field. State intervention is important in restraining corporate excesses, enforcing standards and ethical corporate governance, with the ultimate aim of protecting stakeholders. Market participants do not always behave rationally, but are rather subject to cognitive biases and societal habituation. Therefore, a deeper understanding of behavioral finance can provide policy makers with a more comprehensive understanding of consumer behavior when developing and implementing policies.

9 SUB-PRIME CRISIS 9 References Brummer, A (2008)The Crunch: the Scandal of Northern Rock and the Escalating Credit Crisis. Random House Business Books: London. Hagerty, J.R (2008) trail exposes risky business of Mae and Mac, the Australian. December 11:21 Kawai, M. (2010) Reform of the International Financial Architecture: An Asian Perspective. The Singapore Economic Review 55: Krugman, P. (2009)The Returns of Depression Economics and the Crisis of W. W. Norton and Company, Inc. Mah-Hui, L., &Chin, L. (2010)Nowhere to Hide: The Great Financial Crisis and Challenges for Asia. ISEAS Publishing. Schumer, C.E. & Maloney, C.B (2007)The Sub Prime Lending Crisis: The Economic Impact on Wealth, Property Values and Tax Revenues and How We Got Here, Report and Recommendations by the Majority Staff of the Joint Economic Committee, US October

Global Financial Crisis. Econ 690 Spring 2019

Global Financial Crisis. Econ 690 Spring 2019 Global Financial Crisis Econ 690 Spring 2019 1 Timeline of Global Financial Crisis 2002-2007 US real estate prices rise mid-2007 Mortgage loan defaults rise, some financial institutions have trouble, recession