The Financial Crisis, How We Arrived here
This paper discusses the major reasons behind the recent financial disaster which has affected every country economically one way or another. The crisis did not just appear out of the blue but it had been accumulating since the ending years of the last century. There are many reasons for this turmoil but the triggering mechanism was the substantial decline in real estate prices which began in late 2007. As the US housing prices declined it became more difficult to refinance loans while foreclosures and default on mortgages became common. Many of the large financial firms and banks had invested heavily in mortgage backed securities which are more commonly known as subprime mortgages because of high risk and low profitability. When the foreclosures and defaults started they also affected the securities which depended on them causing the firms to face huge losses. The largest five banks of America either went bankrupt or had to be provided with liquidity in the form of Government support or acquisitions. The long term consequences of investing in these instruments were not seen as the banks and brokers were gaining profits in the short term. This crisis not only affected America but the entire world economy is under pressure and the financial and credit markets around the world face a remarkable liquidity crunch. The main causes of the financial crisis discussed in this paper are greediness, the decline of housing market and poor credit management.
The desire for more and more has affected the decisions made by humans since the beginning of time. This greediness affects us individually and as a nation. Our economy is based on credit and credit instruments. The wants of people never diminish and if there is credit available then these wants continue to grow. The people start spending more than they can afford in satisfying these wants and the Government also spends more than it receives. This credit is available to people in many forms such as credit cards, mortgages, auto loans and personal loans. The credit based economy makes it easier for people to spend more than they earn and can actually afford. During the past ten years there was minimal check and balance of this credit and it became uncontrollable. The mortgage brokers who act as intermediaries decide who gets loans based on mortgages and pass the responsibility of these loans to other parties by converting them into mortgage backed securities and investments. The mortgage brokers were just concerned with the money they were making and not realizing consequences if eventually these loans were not paid. This practice encouraged many people to obtain loans without considering repayment options. The subprime mortgage crisis thus evolved, as a number of these loans were granted on low value assets and eventually ended up as bad investments. The large firms which heavily invested in these subprime mortgage securities did not realize that the investments were heading to a dead end and a financial collapse was in store for these investments (Patrick, 2008).
The Decline of Housing Market
The major reason for the financial crisis was a steep decline in the once booming US housing sector. In September of 2007 house sales plummeted to 5.25 million with the average sales price falling 4.2% to a level of $211,700 (British Broadcasting Corporation, 2007). This sharp decline in housing prices increased the mortgage rates and it became hard for many homeowners to get mortgages on their homes or to change houses by obtaining finances through mortgages. Many homeowners were forced to leave their properties without paying their mortgage as it had increased in value as compared to the real value of the property. This resulted in a domino effect causing foreclosures and defaults on many mortgages which not only affected the homeowners but also the financial institutions and banking sector. The mortgage backed securities lost significant value due to the decline in housing prices and the banks suffered huge losses.
Poor Credit Management
As discussed earlier, the US economy is based on credit and people spend a lot more than they can afford. The use of credit cards is common practice even for bigger payments. When the payment amount increases the limit of a credit card another credit card is used. The credit card debt of America has risen by 25 percent since the past 10 years and the default rates have increased by one third since 2006 and people pay penalty fees of up to $15 billion per year (Graham, 2009). When the credit cards have been used up to their limit people can obtain various forms of loans from financial institutions. This shows the high dependence of American people on credit. The use of credit has increased in the past 10 years as mentioned above but the regulations concerning the repayment of debts were not considered. People were granted loans and mortgages without proper verification and in the process the standards set for credit analysis were ignored. The mortgage brokers unwisely accepted loan applications and transformed poorly priced mortgage assets into attractive investments by bundling them with other securities. When the people defaulted on the mortgage repayments the banks were worst hit due to heavy investment in these mortgage backed securities.
We have seen the main causes of the financial crisis and can conclude that the crisis evolved mainly due to poor credit management and the credit influenced culture. In order to get out of this crisis we need to look forward and envision what measures can be taken to make the situation better. The US Government has proposed a bailout plan for the banking industry which includes injecting liquidity into the banking sector. Many analysts and economists are of the view that the financial crisis is more of a short term nature than a long one as the outlook for 2010 looks positive and the global economy will start to recover in 2010 (Eghbal, 2008). The financial crisis has taught us that using credit for each and everything and going way over our heads in using credit is not a very good idea and we need to focus more on fundamental strength than credit ratings.
British Broadcasting Corporation. (2007, October 24). Sharp Decline in US Housing Sales. Retrieved June 2, 2009, from News.bbc.co.uk: http://news.bbc.co.uk/2/hi/business/7060346.stm
Eghbal, M. (2008, October 24). Global Financial Crisis: Decline in Short-term but Recovery by 2010. Retrieved June 2, 2009, from Euromonitor.com: http://www.euromonitor.com/Global_financial_crisis_decline_in_short_term_but_recovery_by_2010
Graham, L. (2009, May 19). Credit Card Legislation Passes in Senate. Retrieved June 2, 2009, from uspoverty.change.org: http://uspoverty.change.org/blog/view/credit_card_legislation_passes_in_senate
Patrick. (2008, September 29). The 2008-2009 Financial Crisis – Causes and Effects. Retrieved June 2, 2009, from Cashmoneylife.com: http://cashmoneylife.com/2008/09/29/economic-financial-crisis-2008-causes/