In recent years, we always heard somebody talk about global recession, financial downturn or financial crisis from everywhere. We have also seen many people lose their jobs, and several banks or even a country, Iceland, go bankrupt. What happened to the world? How did it happen and why? A well-known quotation: “When America sneezes the world catches a cold,” always can describe the big picture of the global financial crisis in general, and there is no exception this time. The ongoing financial crisis, also known as the subprime mortgage crisis, was started by a dramatic rise in mortgage defaults and foreclosures in the United States. Many financial institutions, financial instruments and fiscal wizardries coalesce together to contribute to this whole crisis. Nevertheless, as we known, the complex phenomena can always be attributable to simple mechanisms and motivations. If we can grasp the information about who the major players are and what their strategies in the subprime mortgage game, the story of the financial crisis will not be complicated to understand but rather interesting. In fact, the whole process of this recent financial crisis can be divided into four stages.
The first stage can be dated back to September 11, 2001, the chairman of Federal Reserve, Alan Greenspan, set out to adjust the interest rate to historic low to keep economy strong. This policy made it easier for buyers to purchase a house, because they could pay less interest. Additionally, three kinds of participants could get benefits from it. They are the families which want to buy their own houses, the mortgage brokers and the lenders (banks). Most of families cannot afford to pay the full price for the house all at once, so they often save for down payment. If the family has good credit history and the proof of income, the broker will connect the family to the lender for helping them get their mortgage from lenders. During this stage, because of lower interest rate many families got the mortgage approvals and bought their own houses. The lender received the regular payments including principal and interest from house owners every year. Brokers also made nice commissions from connecting those house owners and lenders. Everything worked out nicely; the policy succeeded in growing the economy of the United States.
During second stage, from about 2002 to 2004, the lower interest rate not only attracted more families to buy houses, but also made the investment banks start searching for new avenues to improve their returns. The reason is that the lower the interest rates, the more money they could borrow to amplify the outcome of a deal. In finance, it is called leverage which is the major way that an investment bank makes money. The leverage, generally speaking, is borrowing money from somewhere to invest some financial instruments at a low price, selling out at a high price, paying off the debts and earning the large returns. In other words, the leverage allows people to make big profits with little capital. In 2001, a Chinese statistician, Xiang Lin Li, introduced an influential model which allowed for the rapid pricing of CDOs (Collateral Debt Obligation). The model made a CDO, a financial wizardry, which turns mortgages into securities in order to be sold in the global markets; therefore, it became a popular leveraged financial instrument for investment banks. From then on, both the lower interest rate and useful financial model made investment banks eager to borrow money to buy mortgages from lender banks, because they could package mortgages into CDOs and sell them out to global investors. Investors also love the CDO owing to the high returns and low risk. To sum up, during this stage CDOs made lenders offload risk, helping investment bankers to create a large leverage ratio, and offering a lucrative and safe returns for investors. Everything worked out perfectly. CDOs, just like alchemy, effectively pushed up economy growth, keeping house prices rising, and making every participant earn tremendous money.
The turning point occurred during stage three from 2004 to around 2006. The demand for mortgages and CDO s kept rising, while the families who were qualified for a mortgage to buy home became less and less. Thus, brokers and lenders started to expand their subprime lending program. Subprime lending is defined as extending credit to borrowers whose characteristics exhibit a significantly higher risk of default than traditional bank lending customers; in most cases, lenders avoided or restrained the subprime lending due to high risk. However, as economy and house prices kept growing by leaps and bounds, anyone who slowed down or fell behind would have been interpreted as a decline in their market share compared to others. At this moment, greed started to kick in, and a strong incentive for people to make more bets--speculating or gambling. That is why lenders and investment banks kept broadening the scope of the subprime mortgage lending, even though they knew those who with poor credit histories may bring about higher risk of default and resulting loan losses. Besides, they became over-confident as they all thought they had figured out how to take on risk and make money more effectively by CDOs. However, they just fooled themselves into thinking they were safe and high ground.
In order to mitigate the housing bubble, Alan Greenspan, the chairman of Federal Reserve, began raising interest rates in July 2004. Then a series of rate hiked from 1% to 5.25% within two years. In 2006, the beginning of the last stage, as Greenspan wished, the great housing bubble finally started to deflate; nevertheless, it was also the detonator of the subprime mortgage crisis. First of all, as interest rates rose, more and more subprime borrowers could not afford the high payment. Therefore, they stopped paying their mortgage and their houses were in foreclosures which increased the supply of houses for sales. On the other hand, the high interest rate reduced the demand of the house. A simultaneous decrease in demand and increase in supply unquestionably placed downward pressure on house prices. Accordingly, the house price was not rising anymore; it fell down instead. This created an interesting and critical problem for house owners who still paid the mortgage. As all the houses of their neighborhood went up for sell, the value of their house went down together. They wondered why they should pay back the mortgage when their houses are not worth that much. Thereupon, they also defaulted on their mortgages one after the other, and which made house prices escalate into a crash. Brokers, lenders and investment banks really suffered from this bad situation, because they held large number of worthless houses in foreclosure which no one wants to buy. At the same time, they had been borrowing millions or billions of money, but they failed to pay back their loans. Hence, they finally fell into a financial crisis in 2008. For example, Lehman Brothers, the fourth largest US investment bank, went bankrupt; Merrill Lynch, HBOS, Alliance & Leicester were taken out by other banks; Northern Rock and Bradford & Bingley are nationalized; Bear Stearns, RBS, Citibank, Freddie Mac and Bank of America received Federal bailout funds. On the other hand, the collapse of housing bubble also made CDOs become valueless; lots of investors watched their money burn up. Consequently, home owners forsook their houses; financial institutions lost most of their money and faced large debt problems; the confidence in market slumped; the whole financial system was frozen and dark.
As a matter of fact, we are still in the last stage of the crisis now, because the U.S. house price index signals a 30-35% potential drop in this coming year. That indicates that the world economic recession is not bottoming and the prospect of the world economy will not be bright in the short term. However, every cloud has a silver lining; most of the countries in the world have been pumping more money into their economy. There’s always hope and we will get through this.
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