The middle and the end of 2007 were marked by a widespread crisis in global financial markets as well as a significant decrease in their activity. This situation quite shocked the wider society in many countries. However, it would be wrong to assume that the current world financial situation suddenly arose. It was quite predictable, because even in the middle of 2006 the first forecasts of a possible financial slowdown could be recognized in many countries, primarily in the United States.
The global financial crisis, especially as deep as it was, was a dynamic process. The financial situation is constantly changing and, therefore, it is not easy to predict it. For most experts, the financial crisis was a complete surprise, which they had been unable to predict. This is due to lack of efforts or low-skilled economists. It is rather the natural result of fundamental changes in the global economy, called modern financial growth.
The crisis that broke out in 2008 was also a surprise to the leading financial institutions of the world. In the late 2007, it was widely believed that the recession in the U.S. had not taken place. However, it was also believed that in case it happened, it would not have a major impact on the events in the world and that the world economy would continue to develop dynamically. In autumn 2008, the National Bureau of Financial Research of the USA announced that the U.S. economy had been in a state of recession since the end of 2007. Experts recognized that the world had faced the deepest financial crisis since the times of the Great Depression.
Being the product of sharp contradictions in the market system, the scale of the financial crisis, which took place in 2007-2010, rapidly expanded and caused serious negative financial and social consequences. Today, the United States is officially recognized as the source of the global crisis. This fact is being recognized directly or indirectly by the absolute majority of countries around the world, including the U.S. authorities.
Thus, today there is an acute problem of studying the causes of the U.S. mortgage crisis, which led to the global crisis and the impact of the financial crisis in the U.S. on the global financial system. The existing problems identify the relevance of this work. The object of the study is financial systems of the world. The subject of this study is the U.S. economy, the economy of world countries, as well as the mechanisms of their interaction. In accordance with the relevance of the theme, a goal of the research paper has been set up, which is to determine the causes and manifestations of the U.S. financial crisis, as well as the mechanism of the nature of their impact on the global economy.
The causes of the financial crisis that started in 2007 are related to the financial sphere. However, its impact went far beyond the economy. For a variety of reasons – from everyday stresses to behavioral finance – public opinion is an important element that must be also considered in the study of the crisis. For the U.S. government, politicians of the world, public organizations and corporations public opinion has been one of the priorities of the anti-crisis activities. Thus, the present research paper will also try to consider the roles of different actors in the formation of public opinion in America in 2007-2010, as well as analyze their problems and work efficiency.
In order to have an idea about the causes of the financial crisis, it is necessary to review the progress of its development briefly. The financial crisis began in 2007 and became global in 2008 after the collapse of the financial markets. However, its cause must be sought in the events that took place a few years earlier. According to David Lereah, Chief Economist at the National Association of Realtors of the USA, house prices are doubled every 10 years. In 2004, George W. Bush, the U.S. President stated that home ownership brought security, dignity and independence (Bush, 2004). These and similar words helped the U.S. real estate market achieve the maximum level of prices in history. The head of the FED, while being a candidate for the position, in 2005 declared that if there was a moderate cooling of the real estate market, it would not have significant impact on the growth of the economy. The Washington Post article was titled: “Bernanke: There’s No Housing Bubble to Go Bust” (Henderson, 2005). Henry Paulson, the head of Goldman Sachs and later the U.S. Treasury Secretary, gave an optimistic financial outlook for the future growth. Despite the above quote, there was no 100% of optimism in the ranks of experts and politicians within 2 years prior to the crisis. Economist Paul Krugman in the New Your Times article warned that the bubble would explode with cotton and deflate releasing a hiss. Paul Krugman wrote that the recession in the real estate market could be the beginning and that it was the time to start to worry about it (Odlyzko, 2010). In the second half of the last decade the mortgage market started to grow actively in the United States, including through the issuance of the subprime mortgages with the main idea that if house prices were rising continuously, it was possible to give a loan secured by realty to almost anyone. As a result, property prices reached an all-time high by 2006 as it can be seen in the chart represented below (Show Web Site & Articles, 2010).
However, at some point the number of risky borrowers became critical and prices for houses, put up for sale by banks in result of defaults on mortgages, started to reduce (an increased supply). As a result, there were even more personal defaults, as well as the greater number of houses with a sign “For Sale”.
Looking for a way out of the situation, banks found that pool of risky borrowers had significantly less risk of default than each individual borrower. This is why they created the securities that provided payments on mortgage. These securities were purchased by a variety of investors – from pension funds to commercial banks around the world.
However, as a result of an increasing “snowball” of defaults on mortgages and the reduced cost of real estate pools of mortgage borrowers also became unreliable. Investors started to lose money on investments in the U.S. mortgage market, the volume of which was $1.3 trillion in March 2007.
The losses, combined with the misinterpretation of institutional participants of the financial market, and abuse of power by professional financiers (as it turned out even during the outbreak of the crisis) led to the bankruptcy of the investment banking business of Lehman Brothers. That was the event, after which all business newspapers and Western politicians started to talk about the financial crisis. Investors and ordinary people started to discuss it as well (Economist.com).
National and global financial crises are inevitable due to both risks (risk of loss) and opportunities (innovation, creative solutions). Besides, a crisis almost always occurs unexpectedly, despite the disturbing symptoms and persistent warnings of analysts. That is what happened in 2007 after the bankruptcy of individual mortgage companies in the U.S.
The U.S. economy has repeatedly faced serious challenges, which include the Great Depression in 1929, the crisis of the 70s, associated with an increase in oil prices and high inflation, the stock market crisis of 1987 and the collapse of the “bubble” of the “dotcoms” (2000-2002) related to the stock of Internet-based companies. The middle of 2007 in the United States was marked with the manifestation of a new crisis, which served as the epicenter of the mortgage sector. According to Sepp and Frear (2011), the crisis can be divided into 3 stages. They stated:
“The first phase, involving its outbreak, lasted from autumn 2006 till August 2007. In the second phase, lasting from September 2007 till August 2009, the crisis proceeded, and the credit market collapse significantly complicated the situation of banks in many countries. The third period, from September 2008 until the present day, has been the maturation phase of the crisis, involving numerous interventions of governments and financial institutions from the United States as well as other countries” (Sepp & Frear, 2011, p. 44).
The crisis in the mortgage sector had taken a truly grand scale. Thus, Jansen, Beulig and Linsmann, (2009) pointed that “a housing bubble is characterized by rapid increases by the valuations of real property such as housing until unsustainable levels are reached relative to incomes, price-to-rent ratios, and other economic indicators of affordability” (p. 6). For example, it was estimated that the number of insolvent debtors under the mortgage in the U.S. had been increasing every quarter by tens of thousands of people. As a number of defaulters, banks were forced to alienate their homes due to non-payment of debt. Therefore, it is relevant to consider the failure of a large number of citizens who took home loans to repay them on time as a direct cause of the crisis in the United States. A number of factors contributed to such a state of affairs. As a result of the crisis of 2000-2002 the recession started in 2001. In order to improve the situation, Chairman Alan Creenspan, the then head of the Federal Reserve System (hereinafter – the FED), lowered the refinancing rate from 6% to 1% for the period from 2001 to 2003. At the same time, the government had increased public spending by cutting the taxes that led to a rapid growth of the budget deficit. In the period from 2001 to 2005 a rapid growth in property prices was experienced in many parts of the U.S. It was caused by lower interest rates of loans, “soft” borrowers’ approach to assessing the lenders’ solvency, as well as higher propensity of households to home ownership (Taylor, 2009). In the second half of 2005, houses started to fall in prices. For borrowers who received loans recently, which were almost equal to the cost of a house (the ratio of the size of the loan and the value of the mortgaged property close to 100%), the fall in property values was an important cause for the failure to pay the loan. It is also necessary to take into account the fact that the non-standard loans were given to borrowers who had solvency problems in the past. An increased housing supply in the market, a tightening of the conditions required to obtain a loan as well as rising interest rates led to a further decline in housing prices.
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Many experts believe that the decline in prices in the housing market led to a recession in the U.S. economy. In 2005, lenders, operating in the market of non-standard loans, in order to achieve a competitive advantage held down interest rates, which led to the improvement of the quality of their loan portfolios, including standard loans. The main problem was that the loans did not bring enough profit. Thus, in order to increase profits, unconventional lenders started to raise interest rates, which led to a decrease in the number of new customers and the volume of loans. Non-standard lenders were more focused on maintaining and increasing the indicator of “the volume of loans”, by which investors assessed the potential of a company’s growth and the change of which could affect the market value of the shares of the company. In order to do this, lenders started to make exceptions to the leading standards, which contributed to the lack of state control over the sector of non-standard loans. With the growing competition within the market of non-standard loans, some lenders brought new products to the market that allowed the borrowers to get a loan without creating the documentation on housing, initial payment, with a low credit rating and unconfirmed income. The number of defaults on such high-risk loans started to increase as the crisis unfolded in the housing market, which meant losses suffered by the companies to which they were issued. As a result, at the end of 2005 there was a change in lenders` strategies. From the competition and costs associated with a reduction in the interest rate, they moved on to credit conditions associated with the simplification of lending standards.
The U.S. financial growth in 2005- 2006 was about 3.2%; it had led to the “overheating” of the economy, so Alan Greenspan gradually raised the discount rate from 1% in summer 2004 to 5.25% in summer 2006. Up to this point, the growth of consumer demand in the U.S. was supported by cheaper and more available credit, as well as the continuous growth of the prices of all assets, including real estate. Then positive factors practically disappeared for consumers. The cost of money increased and the prices started to decline, while the debts and financial obligations did not go anyway. The level of direct mortgage service expenses and consumer credit rose to an all-time high (14.5%). These payments came closer to 20% with the obligation to pay rent, insurance and property tax, as well as car rentals (Sepp & Frear, 2011).
The manifestation of the crisis is associated with the moment when New Century Financial Corporation, which was the largest U.S. mortgage company engaged in making loans to risky borrowers, gone from the New York Stock Exchange by announcing on February 7, 2007 that by the results of 2006 significant losses from its operations were expected and it intended to review the financial results of the previous quarters. On April 5, 2007, New Century Financial Corporation declared bankruptcy and field for protection from creditors, which included such banks as Morgan Stanley (debt of $2.5 billion), Credit Suisse Group ($900 million), Bank of America ($600 million) and others. On March 13, 2007, the company stopped to list its shares on the New York Stock Exchange. In early March of 2007, New Century Financial Corporation completely stopped to disburse a loan.
Over the next few months, dozens of these companies suffered losses or went bankrupt. In summer 2007, the crisis affected investment funds of major financial companies that invested in mortgage-backed bonds, such as Bear Streams, Goldman Sachs, BNP Paribas. By September 2007, the two largest mortgage companies such as Fannie Mae and Freddie Mac found themselves on the edge of bankruptcy, which accounted for 44% of the mortgage market. The U.S. government was forced to take control of them and practically nationalized them.
Investment banks started to disappear as well. Thus, Bear Streams was sold to JP Morgan Chase, Lehman Brothers went bankrupt, the largest investment bank Merrill Lynch was sold to a commercial Bank of America for 70% of its market value, the shares of Morgan Stanley lost 49% of the shareholder value just in eight trading sessions, as well as the shares of Goldman Sachs lost 51%. As a result, there were only two independent investment banks that remained at Wall Street at that time. Then the crisis hit such major U.S. financial institutions as Citigroup, Bank of America, JP Morgan Chase, Wells Fargo, and others (Taylor, 2009).
The upheavals in the banking sector were accompanied by the undermining of creditors’ and customers’ confidence, an increase of credit risks and financial difficulties. The crisis spilled over into the sector of production. Thus, market supply exceeded demand, which started to decrease. The situation was complicated by massive layoffs in the U.S. auto industry. Such giants of the car industry as General Motors, Ford and Chrysler ended up in financial distress. Gradually, the crisis spread to other sectors of the economy and the companies all over the country started to face bankruptcy. On February 24, 2009, the U.S. President Barak Obama stated that the economy of the country was in the crisis and every 30 seconds one company of the country was going bankrupt. Thus, the main cause of the U.S. mortgage crisis, which led to the global financial crisis, was the venture mortgage crisis, namely mortgages of people with low-income and poor credit history.
The main purpose of the anti-crisis policy of the United States was the stimulation of market demand and a powerful assistance provided by the major banks and corporations, which contributed to the emergence of the crisis with their irresponsible policies. At the same time, the significant capital, including the anti-crisis allocations, continued to be used for speculation.
These processes were accompanied by redistribution of property in the form of acquisitions, including some of the largest U.S. banks. The crisis decline in production was accompanied by a reduction of bank loans. The decline in production and increased risks led to a decrease in investment and demand for imported goods.
Initially, the anti-crisis measures had been developed in the United States during George W. Bush’s administration in the form of the Paulson Plan and then continued under President Barack Obama. Thus, a new anti-crisis program included an appropriation of $787 billion. Unlike George W. Bush neo-monetarist polices, Obama’s program called for stimulation of consumer demand through tax benefits, measures aimed at combating unemployment, as well as an increase of job opportunities. A lot of money was planned to be directed on investment and stabilization of the banking system. In addition to this, Obama’s plan was aimed at tax increases on capital gains and dividends (from 15% to 20%), the abolition of tax privileges for the wealthiest people in 2010 (i.e., 2,600,000 people whose annual income was more than $250,000), the introduction of taxes on profits earned abroad (profits of transnational corporations). These measures might ensure the budgetary receipts of $350 billion per annually. At the same time, tax privileges were preserved for the majority of the population. The basis of the President’s Barack Obama anti-crisis program was based on allocations for stimulating consumer demand through tax cuts, expenses on job creation and support of major banks and corporations, which had faced “bankruptcy threat”.
The initial costs for expanding consumer demand accounted for 30% of anti-crisis amounts (more than $330 billion), including 18% of the investment amount intended to cover the labor force (about $140 billion), which ultimately amounts to $470 billion or more than 42% of all anti-crisis allocations (Taylor, 2009).
The use of 58% (about $650 billion of appropriations) for investment purposes had the following feature: in the form of bank loans they were intended to finance working capital, since fixed assets were underutilized because of the crisis. Given the multiplier impact, it should have ensured the functioning of all (including the basic) capital in the amount of about $3 trillion, which should have led to financial growth and offset the costs of the crisis.
It is necessary to point that the U.S. Federal Reserve had a number of unconventional salutary effects. The U.S. banks, using a new temporary crediting program named Term Auction Facility (TAF) adopted by the FED in December 2007 to mitigate the effects of the crisis in the credit market, took huge loans from the FED. The use of this program, which allowed banks to borrow money at low interest rates, led to the fact that the amount of loans for a period of one month by the middle of February 2008, provided by the U.S. banks, reached $50 billion (Davies, 2010).
The TAF program was part of a complex of the measures, developed by leading Western central banks to stabilize the situation in the money markets. Before the introduction of this program, the banks had to either raise funds on the open market, or to use the so-called “discount window”, which involved the provision of loans to the FED at the discount rate. In December 2007, the banks refused to use the “accounting window”, despite the difficulties caused by the lack of liquidity, which they faced when raising capital on the open market.
On March 11, 2008 the Federal Reserve announced a new program – the Term Securities Lending Facility, or TSLF. The FED provided the primary dealers with treasury bonds worth up to $200 billion for a period of 28 days and took less safe securities as collateral under this program.
The TSLF program had a different form than all other programs, because it implied an exchange of one bond for another; therefore, it was possible to obtain the liquidity of all markets, except for money. The program was designed to expand a bond portfolio of the Treasury, demanded during a liquidity crisis. Davies (2010) stated:
The 2008 Treasury paper argued for far-reaching reform. In future there should be a market stability regulator, the Federal Reserve, a prudential financial regulator which pulls together different banking supervisors and a new federal charter for insurance companies. In parallel, there would be a new business conduct regulator, which would take on most aspects of the SEC’s and the CFTC’s responsibilities (p. 58).
At the same time, the FED took a huge credit risk trying to reduce the liquidity risk. An exchange of the government bonds with a remarkable reputation in the less safe assets reduced the quality of the FED’s balance sheet, as $200 billion accounted for almost a quarter of all the assets of the FED. Banks were increasingly offering the FED dubious assurances as collateral, however, not taken by anyone anymore, and, therefore, it made them a threat to the U.S. banking system.
On the other hand, the use of these instruments allowed to prolong the period of borrowing money from the FED, expand the use of different assets as collateral for loans, open access to the FED loans for a wider range of financial institutions, as well as apply more flexible mechanisms for the formation of interest rates on loans of the FED. In particular, the FED started to perform the function of the last instance creditor for investment banks, which were the primary dealers of the government securities market that could use the so-called “discount window” (the program PDCF – Primary Dealer Credit Facility) without being a depository organization (Lybeck, 2011).
On December 16, 2008 the Federal Reserve reduced the access to credits reducing the base rate to its record level of 0.25%. This meant that the FED was running out of space for traditional maneuvers to stimulate lending.
The U.S. budget for 2009 was designed with an unprecedented deficit of $1.75 trillion, which corresponded to 12% of GDP. With the outflow of foreign capital, this meant a simultaneous increase in public debt. On March 19, 2009 the FED announced the program of allocations in the amount of $1.15 trillion, of which $300 billion was supposed to be used for buying long-term government securities, $750 billion – for buying the same mortgage-backed securities (“bad assets”) and $100 billion – for purchasing debt of Freddie Mac and Fannie Mae (Lybeck, 2011).
Thus, the features of the U.S. mortgage crisis were the financial infrastructure of the country, construction of exploitative pyramids and “bubble inflating” (i.e., an artificial inflation of the financial recovery on the basis of speculation and price increases). The consequences were disastrous for both the United States of America and the whole world: the loss of confidence in global financial markets, the stock market panic, capital flight and the loss of depositor confidence in banks and the collapse of the largest of them. The most advanced economy in the world became the starting point of the global financial crisis of that time.
The U.S. mortgage crisis that started in the late 2006 with mass defaults on home loans, due to the haphazard use of derivative financial instruments, soon spread to the entire U.S. financial sector and then to other countries. A lot of companies had gone bankrupt or had suffered serious losses, which led to a sharp reduction in lending and set the stage for the crisis of the U.S. economy.
The U.S. mortgage crisis was due to the fact that the banks gave loans larger than the market value of the property, which people planned to buy. Thus, the loan amounted from 120% to 130% of the property value, assuming that the rest of the money people would spend on landscaping their new home.
The mortgage crisis in the U.S. contributed to a reduced ability of banks to issue new loans because money did not come back to the banks. Thus, the banks started to take money from each other and the interest rates rose. Mortgages that were processed in the issuance of mortgage loans held as collateral securities and people stopped buying because of the increased risk in the stock market. As a result, banks suffered billions in losses.
The U.S. mortgage crisis of September 2008 triggered the crisis of liquidity of the global banks, which stopped to issue credits, particularly loans to buy cars. As a result, sales of auto giants started to decline. The crisis spread to the real economy and, therefore, the recession began, as well as the decline in production; customers started withdrawing savings from their accounts in large numbers. The largest bankruptcy of Lehman Brothers made people doubt the possibility of payments of insurance companies, which were insured against the risk of bankruptcy; as a result, that led to a sharp increase in lending rates.
Shortly reliable borrowers started to experience credit problems also. The mortgage crisis had gradually transformed into the financial crisis and affected not only the United States. World stock market quotes fell sharply. The possibilities of obtaining capital for placement of securities were reduced significantly for companies. By 2008, the crisis became global and gradually began to manifest itself in the declining output, falling demand and commodity prices, as well as raising unemployment.
The largest crisis in recent years affected almost all developed countries; among them the United States suffered the most. The U.S. stock market, especially in the face of the financial and construction sectors, also experienced the negative effects of the crisis and a decline was observed during almost the entire second half of 2007.
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