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The Financial Crisis Explained
Tracing the root cause of international boom and bust in the US housing market
By Dimitar Apostolov (guidance from Georgi Krustev)
"The fuel for the fire"
In its Quarterly Bulletin (Q3, 2009), Bank of England notes that prior to the crisis some major financial systems and institutions (e.g. in the USA and the UK) tied their growth to heavy borrowing. To reinvest trade surplus and profits, other countries (e.g. China) and banks eagerly financed this debt through purchasing securities related to the United States housing market. The choice was based on the assumption that real estate prices can never fall and therefore housing mortages are a safe investment. Due to the high demand for mortage-backed securities, banks extended temporary credit lines at low interest rates to unqualified borrowers. Hedge funds and investment banks (e.g. Bear Sterns, Lehman Brothers) then purchased the loans, bundled them up into attractive security packages and sold them to investors.
As the Bank of England report shows, this system was fraught with under-priced risk. First, banks assumed the price of mortage assets would remain stable in a crisis and did not charge the necessary premium for value fluctuations. Second, the incentive for short-term profit hypnotized all parties to ignore the long-term risk associated with their investment. Furthermore, despite heavy international investment in U.S. housing assets, there was no international framework in place to assess risk and exposure. Finally, banks’ dependence on wholesale markets rather than deposits increased their susceptibility to a market liquidity crisis. Once the turmoil started, all of these factors contributed to its transmission from one sector to whole economies and countries.
The crisis trigger
The Bank of England report shows that the bubble burst when the low cost loans to unqualified borrowers expired, making the latter unable to repay their mortage. This generated a vicious circle that saw lending dry up and push even more home owners into delinquency.
The contagion spreads
Suddenly, investors found toxic assets rather than sound capital in their balance sheets. Bank of England elicits that financial institutions could not determine how much each of them had endowed in mortage-backed toxic assets. As a result, trust evaporated, inter-bank lending all but ceased and the cost of funding increased substantially. To make matters worse, banks used their funds to cover losses instead of offering loans which shrunk household budgets and decreased spending. As loan liquidity dwindled in all sectors, financial turmoil transformed into a real economic slump. Without the necessary borrowing to finance their operations, companies fired workers and contributed to a serious unemployment problem.
As a general rule of thumb, commercial banks that worked with deposits suffered less from the initial shock. With their direct exposure to the toxic assets, however, mortage companies, hedge funds and investment banks endured a hard hit. In many countries (e.g. USA, UK, Germany) governments poured billions into the system and central banks cut interest rates to record lows to restore confidence. Despite the dire state of their companies, however, many senior managers rewarded themselves with hefty bonuses. Not surprisingly, taxpayers who financed the bail-out through government funds felt enraged. Further discontent was voiced against rating agencies that failed to reflect adequately the financial institutions’ change of fortune.
Three years after the start of the crisis, countries around the world were affected either because their financial institutions had invested in mortage-backed securities or because states affected by these toxic assets pulled out their investment to cover losses at home.
What now?
Now that many analysts predict a near end of the financial turmoil, it is imperative to draw conclusions from the newly found flaws in the system. This is why The New Financial Order series on thebeginner.eu will disclose the actions of countries alliances and the world as a whole to fine-tune the capitalist economic model.