U.S Financial Crisis 2008, root cause analysis


Published on

Root cause analysis on U.S financial crisis 2008

  • Be the first to comment

  • Be the first to like this

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

U.S Financial Crisis 2008, root cause analysis

  1. 1. A.HOW DID FINANCIAL CRISIS HAPPEN? MORTGAGE MARKET Model 1: Mortgage market: This model show how the mortgage market works. At first, Brokers connect lenders with house buyers (or house owners) and take commission for each successful deal. Lenders lend money to house owners in form of mortgages. Then, lenders sell those mortgages to banks. Banks buy those mortgages and through the process of securitization will transform those mortgages into securities which are called CDO (Collateralized Debt Obligation). After that, they will sell CDO to investors, other banks, hedge funds and other financial institution. 1.CDO (Collateralized Debt Obligation) - Mortgage securitization Mortgage securitization is a process that transforms mortgages into securities which are called CDO (Collateralized Debt Obligation). Mortgages in CDO were ranked and then were traded like securities. Table 1 is an example of CDO ranking. In order to concretize, imagine CDO was simply a box of mortgages where mortgages were put into 3 smaller boxes named Safe, Okay and Risky. The mortgage payments paid by house owners would be poured into the Safe box first, then the Okay box and finally the risky box. The interest rates rate would be different 3%, 5% and 10% respectively based on different level of risk that each box represent, the box being poured first will have the lowest interest rate and so on. After that, banks would sell those boxes to different investors who prefer different level of risk: the Okay box to investors who always wanted safe investments, the Okay box to other bankers and the Risky box to hedge funds & other financial institutions who loved taking risk for higher return. All of the investments were great and very dependable because the house price would increase forever. The house owners could sell their houses for higher prices in Tran Thi Thanh Thuy Page 1 8/7/2011
  2. 2. future; brokers earned great commission; banks and lenders had great deals; and investorscould enjoy secured investment with 3% return, a lot higher than 1% of Fed rate. Even if badsituation of mortgage defaults happened when the house owners could not afford theirmortgages, banks could still take back the houses and sell for other people for higher price.Thus, mortgage become a very safe investment, somehow seems to have no risk at all. As theresult, securitization had made mortgage become the most widely traded in credit marketand accelerated the form of housing bubble.Table 1: 2. Sub-prime mortgages New problem occurred when qualified house owners already ran out long ago eventhough there were other thousand people wanted mortgages. Thus, brokers, acting only asmiddle men, lowered down conditions for easy credit. There was no requirement for downpayments (deposits), no proofs of income, and no documents at all. Those exotic and riskymortgages were called Sub-prime mortgages (under-standard mortgages). Sub-primemortgages became commonplace and the brokers who approved these loans absolvedthemselves of responsibility by packaging these bad mortgages with other mortgages andreselling them as “investments. (Ryan Guina, 2008). Banks also did not care about the originof Sub-prime mortgages because they would transfers the risk to other investors, bankersand other financial institutions. Besides, as long as house prices were expected to continuegoing up, there were nothing to worry about. In fact, many of these sub-prime mortgages areticking time bombs.Tran Thi Thanh Thuy Page 2 8/7/2011
  3. 3. 3.Expectation of house values appreciation and housing bubble formed In the 1980s when the US actual profit rate declined seriously to the lowest since afterthe Great Depression, the capitalist state applied many economic policies to stimulate theeconomy, especially the Community Reinvestment Act (CRA) encouraging the bankingindustry to target increased homeownership in the US. Support for “affordable housing”became a key part of local & national politics (Whalen, 2008). Moreover, higher growth rateof population led to higher need of home, so more mortgages to buy houses were purchased. Obviously, the stimulus policy together more needs at that time made the real estate ahot cake of which everyone wanted a piece. And the strongest stimulation was manifested byFED interest rate of 1%. For the “cheap” rate, dozens of intermediary banks didn’t hesitate to supplement theirliquidity by borrowing the central bank plenty of cash, then they could make more lucrativeloans and mortgages and other deals. The housing market became hotter and hotter whenvalues of houses went up every month. As borrowers, people, were offered affordable-seeming repayments by banks, higher demand drove up house values. There had been aconsecutive trend of price increase among 1990s. A new rise appeared in the beginning of2002 but still fluctuated slightly. It was in the third quarter of 2003 when the rate actuallymade its effects on real estate market. Then, house prices sharply soared promptly in the 3following years.Tran Thi Thanh Thuy Page 3 8/7/2011
  4. 4. This remarkably higher house prices mean that lenders could lend out even biggermortgages, which translated into more money for the lenders, insurers and investors. How come people could unwarily fall into a fiscal scheme? Traditionally, Americans havebeen acquainted with buying homes by credits. It is experienced that homebuyers should notput the real estate possessions in pledge that they cannot afford and that they should repay apartial amount in advance in order to be ably suffer any one unexpected house price declineand can still have positive mortgage values (Paul Krugman, 2009). In reality, peopleoverlooked basic principles and enjoyed excitement from the flying house prices out there.In response, they decided to jump into the hot playground without any consideration ofcredit-worthiness. Besides, subprime loans which are loans for real estate that are granted toindividuals who do not have the ability to obtain a prime mortgage just engaged borrowersin a little amount of payment in advance; the rest of the borrowed amount plus interestwould be monthly paid. The point here is that once this interest rate got higher, these peoplecould not be able to pay their loans, but they didn’t know or didn’t care about that aspect.What they believed at that time is the real estate would keep appreciating! That’s how thebubble was swelling. A big gap between home ownership demand and affordability is considerable, asindicated in the figure.Tran Thi Thanh Thuy Page 4 8/7/2011
  5. 5. In the side of creditors, they were happy to lend people who couldn’t afford themortgages because they had nothing to lose. Providing that their borrowers defaulted, theyjust needed to seize the houses and put them back on the market where prices were rising.Simple and easy money. Each debtor who was too optimistic even didn’t pay attention tohow qualified what he had in hand as a mortgage was as he wouldn’t keep it. Instead, hewould sell it to investors who didn’t understand what they were trying to put thousands ofdollars in. 4.Mortgages defaults and the explosion of housing bubble: The housing price artificially went up too fast. Figure 4.a shows the home price indexes. Figure 4.a Brokers and banks forgot that the economic favorable condition could be changedsomehow; people might lose jobs and income, etc; that personal defaults could causepayment avoidance. Especially when housing prices were propelled too high, the sub-primemortgages turned out to be unable for the homebuyers to afford their mortgages anymore,or to buy new houses. Housing foreclosure increased quickly until seized houses just can’thandle the situation. Boom! The bubble exploded. Past due sub-prime mortgages rose to18.8% in 2008. The housing price started going down remarkably. CDO now became difficultfor reselling. As the result, even qualified homeowners, who properly had the ability to pay,also wanted to walk away. The reason is they felt it unreasonable to make payments whilethey could buy a new house with much lower price. Mortgages and CDO appeared hard to beTran Thi Thanh Thuy Page 5 8/7/2011
  6. 6. sold. No one wanted to get more bombs, simply because they were well-aware that thehousing bubble already burst. When investors realized what was going on with their money, they gradually stoppedpurchasing CDO. It demonstrated securitized-back mortgages were not saleable, whichmeant they had to suffer all the CDOs without any inflow to come. Bankruptcy wasunavoidable, particularly when mortgages become the largest type of debt, account for morethan 65% in 2000s as shown in figure 4.b. The time bomb finally exploded. 5.The overuse of leverage: The economy at least wouldn’t have to endure such a great loss of two-digit trillions ofdollars if people hadn’t overused leverage. Leverage is borrowing money to amplify the outcome of a deal. How does leveragework? Let’s take an example of Mr. A & Mr. B, who have 10 dollars in hand and want to makeprofit. Mr. A does not use leverage and Mr. B use leverage. Mr. A uses 10 dollars to buy a box,then resells it for 11 dollars and takes profit of 1 dollar. Mr. B, by using leverage, he canborrow 990 dollars more (99 times more than what he has). So he has 1,000 dollars in hand.Mr. B takes 1,000 dollars to buy 100 boxes, also resell at 11 dollars for each. As the result, Mr.B can earn $1,100. After he pays back 990 dollar he borrow with 1% interest and transactionfees, he will have 90 dollars left as profit. Apparently, Mr. B by using leverage can earn profit90 times higher than Mr. A. Leverage can give Mr. B the opportunity to make huge profit. However, it contains greaterrisk. Let consider the case in which Mr. A and Mr. B can only resell their boxes at 9 dollarsfor each. With simple calculation, we can easily find that Mr. A still has 9 dollars, but Mr. Bnot only loses all his money but also incurs a debt of 100 dollars. The reality where abundance of cheap funds exists drove banks crazy with leverage.Most investment banks were leveraged by a ratio of 40 to 1, and they were dealing withbillions of dollars instead of thousands. Government sponsored mortgage giants Freddie(FRE) and Fannie were using leverage closer to 100 to 1, because of their supposedly stricterlending standards and implicit government backing. As you know, when asset prices arerising, this system works like a dream, but lets look at what happens when asset prices(in this case – houses) move downward. Indeed, leverage exaggerates the power of sub-prime mortgage bombs; magnify the destructions to 40 times even 100 times. And that is theTran Thi Thanh Thuy Page 6 8/7/2011
  7. 7. reason made dozens of banks and financial institutions ran into bankruptcy, which led to thecollapse of financial market and finally become financial crisis 2008. B. WHAT ARE THE CAUSES? So, what or who caused financial crisis? The long list of culprits will be: “Congress, for overzealously pushing homeownership; theFed, for keeping interest rates so low; predatory lenders, for taking advantage of unqualifiedand sometimes vulnerable home buyers; and home buyers, for getting in over their heads;the White House, for letting banking regulations become too loose; finance executives, forselling products they didnt understand while enjoying outsized profits; mark-to-marketaccounting, for accelerating the downturn; rating agencies, for mischaracterizing paper; andshort-selling hedge funds, for betting on doomsday—thereby ushering it in.” (Jack , SuzyWelch BusinessWeek issued in 2008, September 25) Those reasons above are all right. It is absolutely true that they are factors (or culprits)that caused financial crisis. However, there is something that we would like to mentionabout. 1. The real wages Figure 7.a Annual growth rate in productivity 3 2.6 2.5 2 1.7 1.5 1 0.5 0 88-98 98-08 Data: bureau of Labor statisticThe annual growth rate in productivity kept increasing since 1988. In the period of1998-2008, it increased up to 2.6% a year, nearly 1% higher than the period of 1988-1998.1% seems to be small but 1% of 14 trillion dollar GDP per year is a huge number.Tran Thi Thanh Thuy Page 7 8/7/2011
  8. 8. However, the real wage of working forces, who created such that increase in wealth, turnedout to get less money. (Figure 7.b)The question is where does that wealth go? If working class could receive truly for theircontribution, they would be able to afford for their houses, able to afford their cars and theywould not occur into huge debt.Figure 7.b REAL WAGES median weekly earnings for college graduates 1060 1050 1040 1030 1020 1010 1000 990 2001 2002 2003 2004 2005 2006 2007 2008 DATA: Bureau of labor statistics, business week Full - time workers without an advanced degree 1.The credit-economy In US and other capitalist countries, the money economy appears as the basis of credit-economy. Figure 6.a present US total market debt as a % of GDP. 1933 is the year of greatdepression. US society was overrun with both borrowers and lenders. A debt of a typicalfamily got swelling (Figure 4.b). In 2008, savings of an average household was only $392whereas the debt became $117,951, 300 times bigger than savings. Consumer debt,encompassing mortgages, home equity loans, installment loans, and credit cards keptgrowing and there is no signal that the growth would slow then. Among them, mortgageswere increasing rapidest.Tran Thi Thanh Thuy Page 8 8/7/2011
  9. 9. After all, a ripple effect from the collapse of subprime mortgages froze the credit marketand finally led to financial crisis over the US. According to the article “The U.S economic crisis: causes and solutions” by Fred Moseley, issed in March 2009, after World War II, from 1950 to the mid 1970s, the rate of profit in the U.S. economy declined almost 50 percent, from around 22 to around 12 percent. U.S faced the problem of “twin evils” of high unemployment and high inflation. In 1970s, they adopted expansionary fiscal and monetary policies like increasing government spending, lower taxes, and lower interest rates in order to reduce unemployment rate. But then those policies resulted in high inflation. In 1980s, US adopted restrictive policies to fight over inflation but then it lead to higher unemployment. As the result, the “twin evils” effects cause the decline of rate of profit. In order to deal with the decline in rate of profit, capitalists applied a lot of strategies.First, they reduced real wages or at least avoided increase in real wages so that all thebenefits of increasing productivity will lead to increase in rate of profit. Second, they cut backon health insurance and retirement pension funds. Third, they use “downsizing” and lay offas the method to forces workers to work harder or the workers will lose their jobs so thatproductivity will increase. As the result, in the period of 1998 - 2008, the productivityincreased 2.6% per year, nearly 1% higher than the period of 1988-1998 while the realwages controversially reduce dramatically from 2002 to 2008. (Figure 7.a & 7.b). Mostworkers today have to work longer and harder for less. Marx’s “general law of capitalistaccumulation” - that the accumulation of wealth by capitalists is accompanied by theaccumulation of misery for workers - has been all too obvious in recent decades in the U.S.economy (and of course in most of the rest of the world) However, the increase in productivities also create abundant of goods and servicesneeding to be consumed. Besides, the increase in rate of profit also create a lot oftremendously rich capitalist (or investors) who own a lot of money and need a place toinvest their money in or to lend their money out. The only method is to create more andmore credits, more loans so that workers with low income can afford those products. Thus,the American economy is built on credit. Mortgage is a form of credit, which has the fastestgrowth and has the biggest contribution in the structure of credit market. The big questions are: why the working class, the main force creates the wealth of societycan only get little? In order to stimulate consumption, why capitalist do not increase realwages instead of using those money to lend out so that the pressure on credit market wouldTran Thi Thanh Thuy Page 9 8/7/2011
  10. 10. not be that big and economy growth would be more sustainable? Those questions haveexposed huge conflicts in US economy in specific and capitalist economy in general. Figure 6.aFigure 4.bSource: The New York TimesTran Thi Thanh Thuy Page 10 8/7/2011
  11. 11. II.CONCLUSION Financial crisis 2008 started from the housing sectors, the ripple effect from the collapseof sub-prime mortgages had frozen the credit market and finally led to financial crisis overUSA. Huge weigh of mortgage in leverage credit market Mortgage defaults ----------------------------- frozen credit market -------------------------- Credit economy banks bankcrupcy ------------------------------- financial crisis 2008 Dozens of causes can be inferred through the happening. Above all of the causes, theconflicts existing in US economy -the unfair distribution of wealth between the dominantclass (capitalists) and dominated class (working class) - is actually the beginning ofeverything, not only in financial crisis 2008, but also all of the crisis, economic depressions,etc in the past and later on will also be the cause of crisis in future. As long as the dominant class is still capitalists, all solutions (like bail- out) are onlytemporarily effective.Tran Thi Thanh Thuy Page 11 8/7/2011
  12. 12. III.REFERENCES1. Ryan (September 29, 2008). The 2008-2009 financial crisis: Causes and Effects. Retrieved from http://cashmoneylife.com/2008/09/29/economic-financial-crisis-2008-causes/2. Manav Tanneeur. How the economic storm led to the economic crisis. Retrieved from CNN http://edition.cnn.com/2009/US/01/29/economic.crisis.explainer/index.html3. Wendell Cox (October 28, 2008). Root causes of the financial crisis: A primer. Retrieved from http://www.newgeography.com/content/00369-root-causes-financial-crisis-a- primer4. The downturns in facts and figures. Retrieved from BBC http://news.bbc.co.uk/2/hi/business/7073131.stm5. Boom, Burst and Blame – The inside story of America’s Economic Crisis. Retrieved from CNBC http://www.cnbc.com/id/31187744/6. Kimberly Amadeo. What caused the subprime mortgage crisis? Retrieved from About.com http://useconomy.about.com/od/criticalssues/tp/Subprime-Mortgage-Crisis-Cause.htm7. Kimberly Amadeo (January 15, 2008). Housing market 2008 outlook – It’s a burst. Retrieved from http://useconomy.about.com/b/2008/01/15/housing-market-2008- outlook-its-a-bust.htm8. Giáo trình những nguyên lý cơ bản của chủ nghĩa Mac-Lênin - nxb chính trị quốc gia9. Paul Krugman (2009). The return of depression economics.10. Fred Moseley (March 2009). The U.S economic crisis: causes and solutions. Retrieved from http://www.mtholyoke.edu/offices/comm/news/20700.shtmlTran Thi Thanh Thuy Page 12 8/7/2011