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What Caused the Current Financial Crisis?

As you are all probably aware, the US is currently experiencing the biggest financial crisis after the Great Depression. And just like this past worldwide economic downturn, marked with massive bank failures and the stock market crash in 1929, today we witness the unforeseen bankruptcy of big, trusted banks and extreme market volatility.

But how did we get into this situation? This article will try to explain the original causes of the current US financial crisis and its effect on the world economy.

Preceding Factors Contributing to the Financial Crisis

When examining the causes for the financial crisis most people start directly with the real estate market (the place where the crisis really began) focusing on the subprime mortgages and unscrupulous lenders and casting the blame on the unsustainable real estate bubble which began to collapse in 2006.

Whereas this is true, it is not the whole story. The whole real estate bubble originated mainly as a response to the huge demand of financial assets. And since not many places can actually provide such assets, naturally in such situations speculative bubbles come on the stage and become part of the supply response of financial assets to the demand of such assets.

This was the case with the real estate bubble too and that was one of the main factors leading to the current financial crisis: the excess capital globally pushed an enormous amount of money into the US mortgage market thanks to the securitization and the fact that almost 80% of the US mortgage market is securitized.

The Problem with Securitization of Mortgages

Basically, securitization is a wonderful financial vehicle. Mortgages are pooled together as securities and sold to investors. Of course, as securities, they can also be resold. Securitization creates diversification and liquidity. It also "smoothes out" the idiosyncratic risk of defaulting or going bankrupt.  

Despite the existing lack of clarity and transparency (investors did not fully understand these vehicles and after all, it was hard to get information which houses are included in the pool) regular conforming mortgage backed securities were considered very low risk and were sold to investors not only in the US but also around the world.

And then, the idea of generating higher returns originated. Mortgages were now offered to high risk borrowers too, at the cost of significantly higher mortgage rates. Those subprime mortgages were put in big pools of assets from which the so called "Mortgage Backed Securities" were created. Often, the mortgages were actually broken into pieces and grouped and packaged with other mortgage pieces of the same type. Thus, financial instruments and vehicles like SIV, CMO, CDO, MBS and etc. seemed like a great solution to the great demand of assets and the idea was that the yields on such securitized subprime mortgages would also be higher.

However, the problem with securitization stems from the fact that it does not provide protection against systematic risk. And unfortunately, such a systematic risk was also not priced into the subprime mortgage pools... not until things went wrong and subprime borrowers started defaulting on their mortgages.

Reasons behind the Large Scale of the Crisis

As we already noted, credit rating agencies didn't take into account the possible systematic risk and blessed the apparently low risk securities with AAA rating. Pension funds, mutual funds, some money market funds, banks and investors from all over the world purchased such securities thinking that they are safe. And as for the riskier securities, they also had their clientele - the hedge funds. Thus, the markets absorbed enormous amounts of these securities.

Additionally, because investors considered such securities low risk, they leveraged them. In other words they invested more than they actually had capital for.

This liquidity and the fact that these instruments became so widely spread among investors of all types and sizes now stand behind the great scale of this financial crisis.

The Shock

The subprime lending increased the homeownership rate in the United States significantly and about 5 million people went from tenants to homeowners. As a result, rents went down and house prices went up till they reached unsustainable heights relative to rents.

However, in contrast to the stock market, in the real estate market when the asset prices rise more assets are created through construction. Between 2001 and 2007 the construction of new housing units exceeded significantly the new household formations and naturally this housing bubble could not grow up infinitely.

Thus, when the rise in housing prices stopped in 2006, inevitably many subprime borrowers had difficulty making their mortgage payments. The housing bubble and particularly the excesses of the subprime mortgage market became even more evident when many subprime mortgage lenders began declaring bankruptcy around March 2007. This problem started to gain crisis proportions and yet, the financial authorities and the Federal Reserve believed that it was an isolated phenomenon. Well, they were wrong.

Instead, in mid-2007, the losses in the subprime mortgage markets triggered surprising turmoil throughout the international financial system, given the presumed small size of the US subprime market compared to the global financial markets. The crisis spread with amazing speed to other markets and even to financial institutions that had no direct exposure to the subprime mortgage market.

Confidence in many financial institutions was shaken and the stock market witnessed systemic weakness across financial sectors. The share prices for large, small, and investment banks all significantly dropped and between July 2007 and March 2008, lost about a third of their value. What is more, banks stopped trusting other banks and interbank lending was disrupted.

March was marked with the demise of Bear Stearns, in July IndyMac Bank went into receivership, but the deepest fall of all was the bankruptcy of Lehman Brothers in September, 2008. The financial system was in cardiac arrest and after the events in September, 2008, the panic escalated and the crisis spread beyond the financial markets, now affecting directly the mainstream too.

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