The evolution of the credit panic that hit in 2008 took the world by surprise, captivating World's GDP growth rate to -1.9% in 2009[1]. Illiquid financial sectors, uncontrolled unemployment rates and governments struggling to honour their expenditures are not new phenomenon, but the impact it has caused globally are of great magnitude. Many economists have given their verdicts of what may have caused the global financial crisis but no one concludes the main or prime cause(s) of the crisis. For these reasons, this essay will provide an overview of the causes that created financial crises and then highlight the key factors contributing to the causes.
Introduction
Before the build-up to any crisis, there has always been a 'displacement' as described by Charles P. Kindleberger [2]. Dotcom boom during 1995-2000 as reflected in Fig.1 didn't indicate what it might be after 2000 when leading companies' shares plummeted and forced major players out of the industry. Similarly, we should take in to consideration the measures that allowed investors to react in an irrational manner and foreseeing unrealised profits which motivated them in investing further in to unsecure investments that led to major financial crisis (FC) since Great Depression of 1930s.
There is a strong correlation between financial markets in time of crisis [3]. That means failure of one industry/sector will have repercussion on economy as a whole. The FC of 2008 follows the same pattern and had a causal affects to the world's economy ranging from insurance providers to car manufacturers and airline operator to food suppliers.
The causes of FC are immense but few amongst them are: growth of the housing bubble, easy credit conditioning, weak and fraudulent underwriting practises, sub-prime lending, predatory lending, deregulation, increased debt burden or over-leverage, financial innovation and complexity, incorrect pricing of risk, boom and collapse of the shadow banking system, commodities boom, systematic risk, credit default swaps, securitization practices, high-risk mortgage loans, weak lending/borrowing practices and role of economic forecasting [4]. One way or the other, these factors are interlinked which is discussed in the later part of this essay and contributed to the failure of markets which brought high performing entities to stand still.
According to my opinion, the housing policies, weak underwriting practices and credit default swaps in USA were the key instrumental contributors to FC. Therefore, in-depth analysis will be carried out to provide cushion to my opinion on the above stated contributors.
Housing Policy, Underwriting Practices & Credit Default Swaps
Home ownership in US fluctuated near 64% during 1980 to 1990 as indicated in Fig.2. This is where Congress in 1992 adopted the affordable housing policy, providing easy access to credit for low-income borrowers [5]. Entities such as Department of Housing and Urban Development (HUD), Fannie Mae and Freddie Mac, the government sponsored enterprises (GSE) and Best Practises Initiatives worked in collaboration with US government in providing high-risk loans and adopting reduced mortgage under writing practices[6]. In Fig.3 before the implementation of affordable housing policies, house hold income and prices of houses were almost stationary but after 2000, the wider gap can be noticed between prices and income. The widening gap of prices and income in an anticipation of further price increase, together with competition amongst the government backed entities facilitates them to adopt much harsh practices in providing loans to mortgage buyers. This in return contributed immensely in forcing the housing bubble to go beyond its optimum level.
In connection to the housing bubble, Financial Stability Board in its executive summary highlighted, weak underwriting practices played a strong role in bringing destabilising effect to the financial sector in recent crisis [7]. Last 50 years before the FC, US residential mortgages were solid assets which were kept by banks and other financial institutions as investment. This was only possible because of strong underwriting practices, where borrowers had to prove their financial position before mortgages could be issued.
Sudden changes in underwriting practices raised concerns of why previous practices have to be abandoned? According to Federal Housing Administration, a division of HUD:
FHA is not as strict on credit scoring.
High debt to income ratios: 31/43 percent
100% of down payment can be a gift from: relative, close friend, or employer.
Seller or builder can pay up to 6% of the sales price towards the buyers closing costs, discount points, prepaid, and up front mortgage insurance premium.
Buyer can finance closing costs into the loan, except for prepaid and discount points.
Credit criteria are not as strict as a Conventional loan. In fact, you might qualify if you have filed a chapter 13 bankruptcy and have been in it for at least one year. [8]
What strikes about FHA is when it allows people to qualify for loan who have already filed their bankruptcy. These changes were part of the US government's affordable housing goal. By 2004, loans granted to low-and moderate-income borrowers (LMI) increased homeownership above 69% which remained 64% for the last 30 years as indicated in Fig.2. Because the LMI target audience were limited and many entities were competing to get the bigger slice of the market, they enforced reduced underwriting practices which were the plausible explanation of its decline.
Searching for worst Wall Street invention on Google, the first entry comes up as Credit Default Swaps (CDS) [9]. Several instruments of the same nature were already in market but CDS were first introduced in 1995 by JP Morgan [10]. CDS created a web of linkages amongst all the institutions which were related to sub-prime mortgages. When housing prices were booming and US government's drive for AH scheme was gaining momentum, entities which were providing mortgages to LMI borrowers opted to hedge against the risk of default. The default risks were anticipated to be low but eventually in long run it turns out to be quite high. The hedging against default risk created two main problems. First, the institutions whic were selling these CDS failed to anticipate the risk associated with it. As I have already indicated above, the income of these people were below the median income of that particular area. This created unbearable threat for sellers of the CDS as we could see in the case of American Insurance Group (AIG) where US government bailed out with $150 billion [11]. Secondly, ease to buy CDS made the buyers to involve in riskier trades which they would otherwise. To illustrate my point, Fannie Mae and Freddie Mac, the government sponsored enterprises, took the following stance:
"By 2000, Fannie Mae was offering to buy loans with zero down payments and between 1997 and 2007, Fannie and Freddie bought $1.5 trillion in subprime loans and over $600 billion in loans with other deficiencies that would have made them unsalable in 1990s"[12]. This clearly sums up the adverse affects that CDS pumped in to the financial institution where everyone relied on it which eventually caused big financial institution to fail due to their interdependency and inability to pay their CDS holders.
Conclusion
Many economists and policy makers have given diverse account of what have caused the financial crisis of 2008 and no one singled out any particular reason for the failure. This crisis has many implications which still needs to be studied to further provide evidence of what went wrong and how it could have been avoided. According to my opinion and the reasons mentioned above, US government's affordable housing policy together with weak underwriting practices and heavy reliance on Credit Default Swaps have caused the financial crisis. The crisis infected all major stakeholders ranging from big insurance companies to small commercial banks. To encounter future crisis of this magnitude, governments should change their stance on policies which have been overlooked during the recent financial crisis. Financial instruments of CDS's nature should be highly regulated and a mechanism should be put in to place where limits on government/independent institutions issuing these instruments can be monitored. It provides regulation enforcement agencies to have a proper check and balance which to certain extent will minimise future failures.
Fig 1: Dotcom boom of 1995-2000
http://upload.wikimedia.org/wikipedia/en/d/de/Nasdaq2.png
Source: The technology-heavy NASDAQ Composite index peaked at 5,048 in March 2000, reflecting the high point of the dot-com bubble.
Fig.2
U.S. Homeownership Rate
Source: http://www.census.gov/hhes/www/housing/hvs/qtr108/q108tab5.html
Fig.3
Source: Asian Economic Papers, Fall2009, Vol. 8 Issue 3, p146-170, 25p, 3 Charts, 11 Graphs
Graph; found on p148
