It happened around September –October 2008 when financial institutions and capital market in US faced a meltdown which started in the subprime mortgage sector. IMF estimates that financial meltdown in 2008 had extinguished about US $ 4 trillion from the international stock markets. US witnessed a loss of about US $ 2.8 trillion and the rest of the world witnessed a loss of US$1.2 trillion. It is to be remembered that this is only the beginning of the global economic crisis and it has to run its full course. The fundamental for the current global financial crisis can be attributed to the US subprime mortgage loans and is viewed as a significant model of how such bubble originates and bursts. It is vital to know the fundamentals of the current global financial crisis which would positively guide to better models of such an uncommon and extraordinary financial meltdown. Understanding such models could no doubt would lead to a better appreciation of how it can be forecasted and prevented in the near future. ( Farrok 2009 )
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Impact of current recession
This current recession is said to have started in mid-2008 in Japan, Europe and in U.S.A. The recession is expected to expand in 2009 also thereby resulting in a decline in higher-income country GDP by 0.1 %. In 2009, in the developing countries, overall development is estimated to decline to 4.5% down from 8 and 6.2 percent in 2007 and 2008 respectively. In 2009, the overall global GDP is expected to increase only by just 0.9% which well below the rate reported in 1991 and2001 and has been the highly reduced figure since 1979.
The current global recession will have greater impact on low-income nations due to fall in demand for their exports, declining commodity prices and decline in the flow of FDI or inward remittances. In 2009, global exports volume has declined by 2.1% which is the first time decline since 1982. Cost of exports has soared to peaks due to export credits are drying up and export insurance now costs more (World Bank Report 16).
Global recession has increased the risk awareness for various economies around the globe. On global level, equity markets were worst affected, spreads on corporate debt and international sovereign increased aggressively, rapid depreciation in exchange rates and fall in FDI inflows in 2008 and 2009. ( WB Report 140).
Output in manufacturing sector also significantly fallen to lower levels as consumer spending have declined especially for durable goods. Since December 2007, the aggregate percentage fall in industrial production is notably greater than in any other post-war recession.
For the first time since 1955, the consumer price index in US has turned to be negative despite of a fall of twenty-five percent in energy prices.
What is a subprime mortgage?
It is just opposite to the regular residential mortgage as it involves higher risk of default as it has been sanctioned to borrowers who have no credit rating or permanent employment or other income. These borrowers would not qualify for normal residential mortgages as they have erratic and obscure credit history and do not have noteworthy financial assets. Thus, subprime mortgage can be described as a lower quality residential loans as contrasted to prime housing loans and hence it is being christened as ‘subprime mortgages’, a mortgage that is subordinated to prime mortgage (Baaquie 462).
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The US subprime mortgage bubble exploded in the year 2000 and blown to full scale in July 2007. A global savings glut clubbed with introduction of financial innovations like new mathematical models supported by information technology advancement had added fuel to the subprime mortgage crisis. Further, some investors had wrong conception that ‘risk management’ could manage all kinds of risks and this wrong thought aggravated the bubble to new peaks. ( Baaquie 462)
The US residential mortgage was valued around US$10 trillion during 2007. About three-fourth of the same was offered as repackaged securities which bought out by “Fannie Mae and Freddie Mac,” a US administration patronized mortgage giants. Between the periods 2006 to 2008, subprime mortgage were considered to be around US$ 650 billion. During this period, risky mortgages accounted approximately around US$ 1.7 trillion. (Baaquie 462)
Main reasons for subprime mortgage crisis
One of the reasons for US economic bubble is the introduction of new financial instrument. In subprime mortgage loans , majority of the mortgages were securitized through a new kind of financial instrument which is named as “ Collateralized Debt Obligation “ ( CDOs) and marketed in the global financial market as coupon bearing bonds. Credit rating is used to rate these subprime bonds where AAA rating has been assigned to the lower degree risk bearing bonds while banks retained the “toxic” portions of bonds. Rating agencies has granted AAA rating to about 80% of bonds. Retaining the toxic portion of bonds, banks sold remaining part of all securitized mortgages to investors around the world.
However, at the start of 2007, the majority AAA rated bonds were later found to be toxic category which revealed the collusion of rating agencies in the subprime crisis. Because of AAA ratings, major insurance companies, hedge and pension funds, much government owned institutions and others made their investments in these bonds. The major portion of these bonds was sold to pension funds and European banks. (Baaquie 462)
Though some critics viewed securitization is the chief ground for subprime crisis but actually higher rating to chunk bonds was the chief ground for the subprime crisis.
One another reason is the large expansion of credit due to prevalence of lower interest rates as low as 1% in the year 2003 which remained for more than a year.
Again , the interest rates started to climb up which increased the monthly installments of new financial instrument like adjustable rate mortgages (ARM) and simultaneously property values started to quote low from the termination of the US housing bubble., thereby leaving the home owners not able to meet their financial obligations and lenders without means on their financial losses. This has resulted in an acute credit crunch which threatened the solvency of many mortgage banks and financial institutions. (Jansen, Beulig and Linsman 3).
Due to large scale leveraging created by securitization, there was expansion of credit in US economy as banks had paid only just ten percent of an asset value while remaining 90% being funded by low interest credit. Even the 15% initial down payment for housing loan has been provided from the banks off-balance-sheet funds of its structured –investment –vehicle (SIVs). Thus, to sum up, a home buyer need not pay even down payment from his pocket as the same has been lent by bank in disguised form.
Current recession has resulted in a breakdown in certain activities in financial markets like markets for commercial paper, asset-backed securities and interbank lending. Many established financial firms have either merged with or applied for chapter11 petition. Further, there was a decline in business investment. It appears that the recession would continue all through 2009 and may recover at the fag end of 2010. (Baaquie 463).
US Government and Subprime Mortgage Crisis
Some critics are of the view that U.S government economic policies encouraged the enlargement of the subprime disaster mainly through enactment of “Community Reinvestment Act” which compels banks to lend to borrowers even if they have negative credit history or with low level incomes. Some critics are of the view that withdrawl of “Glass –Steagall Act” was responsible for the subprime catastrophe. US government is now seriously thinking to redraft the role of rating agencies as it thinks that they have conflicted in rating the bonds with toxic element as “AAA” category.
The role of the Federal Reserve in the current U.S recession is also criticized by notable critics. The main role of any central bank is to manage the inflation and to take steps to avoid recessions. They are also accountable for ensuring liquidity. It is heartening to note the Federal Reserve is not assigned with role of avoiding any asset bubbles like housing bubble or dotcom bubble. On the other hand, Federal Reserve is reacting after the burst of a bubble to reduce its collateral effect on the economy and then to stop the bubble. To me, these are not proven concept as Federal Reserve is engaged in postmortem operations only rather than to initiate precautionary measures to avoid such bubble. In other words , Federal Reserve is not toothed with power to snub at its budge any bubble at the initial stage itself and intervene only at its matured stage which is not a proven concept. (Jansen, Beulig and Linsmann 9).
According to survey done by S&P, house prices continued to decline in 2008 which stood at sixteen percent. In the outlook for 2009, it forecasted that tightened credit situations will make it arduous for the US housing sector to resurrect immediately and a deteriorating broad economy, especially one with increasing unemployment rates, will prolong to wield strong pressure on demand for homes. (UN report 2009 90).
Current Recession in USA
According to National Bureau of Economic Research (NBER), is a scenario where there is a noteworthy fall in economic activity which was spread across the economy that endures for than a quarter or months. During recession, there will be a decline in industrial manufacturing, fall in real income, decline in wholesale-retail business and ever increasing unemployment issues. During recession, there will be fall in GDP of a nation due to decline in economic growth.
Current recession in USA has ended up in exceptional reduction in credit. The decline in financial wealth as demonstrated by fall in equity prices has been steep. The fall in house prices is seen as unprecedented. U.S economy has witnessed intensified financial strains and the prolonged decline in the housing sector in 2008 and 2009. In US alone, many banks have applied for bankruptcy under chapter 11 or in the verge of closure or opt for merger or acquisition for their survival. The US economy was in deep trouble after the hitting effect of the financial meltdown in September 2008 following the default of Lehman Brothers, the largest U.S investment bank and the largest U.S insurance company name American International Group.(AIG). According to GFSR, a total amount of capital $ 275 to $ 500 billion is needed as further capital by banks in US alone.
Since banks witnessed large scale write-downs, this has increased the counterparty risks. The solvency of most accredited financial institutions was at stake. Further, the demand for liquidity rose to new peaks and volatility in market was turbulent. As liquidity is in stake, liquid assets were disposed off at fire-sales prices. There was slashing down of credit lines to leveraged financial intermediaries and hedge funds sharply. The spreads for high –grade and high –yield corporate bonds declined sharply and the easy flow of working capital and trade finance was greatly affected as banks have tightened their norms of their lending.
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U.S housing market slump was the main reason for the subprime disaster and has been fundamental for the continuing heavy detriment to the U.S financial system. This has resulted in diminution in household wealth and has stalled the construction activity and it created a major impact on U.S economy.
Current recession in US has aggravated unemployment rates. The main job losers are from financial, housing and automobile industries. According to U.S government Labour Department statistics, unemployment rate in first quarter 2009 stood at 8.1% and rose to 9.7% in August 2009 and this is a twenty-six year record high. The unemployment created due to recession will make it difficult for households to build savings and to repay their mortgages. (IMF Report 2009).
The US currently is going through a serious and protracted recession in its history.
In retort to the financial crisis, US government has fortified its policy stance by legislating the” Emergency Economic Stabilization Act (EESA) “which earmarked $ 700 billion to facilitate the US government to recapitalize the falling US banks. Federal Reserve should prolong to support by enlarging the magnitude of its “quantitative easing operations.” If it is warranted, Federal Reserve should go beyond the extent of removal of impaired securities from the balance sheet of its banks. In the ensuing several fiscal quarters, Federal Reserve should implement the large fiscal stimulus which is required to shore up domestic demand. Fiscal sustainability should be re-established by minimizing the deficits in budgets and sorting out the challenge of ever increasing entitlement spending.
Obama administration has reacted to this scenario and enacted a fiscal stimulus package which is predicted to add more than two percent of GDP to the deficit of the federal government both in 2009 and in 2010.
I suggest that Obama government should initiate further measures to restore fiscal sustainability to succeed its fight against recession. (OECD 2009 68).
Baaquie, Belal E. Interest Rates and Coupon Bonds in Quantum Finance. Cambridge: Cambridge University Press, 2009.
IMF Report. World Economic Outlook 2009.Crisis and Recovery. New York: International Monetary Fund, 2009.
Jansen, Leo H, Beulig Nick and Linsmann Kai. US Subprime and Financial Crisis. New York: GRIN Verlaq, 2009.
OECD Report. OECD Economic Outlook for 2009. New York: OECD Publishing, 2009.
UN Report. World Economic Situation and Prospects 2009. New York: United Nations Publication, 2009.
World Bank Report.Global Economic Prospects 2009. New York: World Bank Publications, 2009.