Introduction
The world is currently grappling with an economic recession that started in the US after the housing crisis. The paper shall look at how financialization, leverage of banks, securitization of mortgages, and toxic assets could have led to this crisis.
The US economic crisis and global recession
Financialization is the process by which a country’s economy and its profit-making ventures are dominated or carried out through financial instruments such as equities, bonds and other financial assets rather than through trade and industry. In the United States, financialization began after the financial sector was deregulated. Shortly after, the country witnessed an unprecedented growth in the latter sector to the point that it represented the highest percentage of investments within the US economy’s performance index i.e. the GDP. (Orhangi, p. 135). Consequently, risk management became difficult, borrowers and savors became disproportionate and savings dwindled. Because of these inherent weaknesses in such a large financial sector, stock market trades no longer represented what was going in the real economy and a deficit began growing. Eventually, investments started going down, employment diminished and so did profits. Because the world depended on the US’s high consumption rates, then international profits also began dwindling in what became known as the global recession.
Leverage refers to the ratio of a bank’s assets to its capital. Ideally, the leverage of banks ought to occur in a condition where an investment can yield high returns but still be in a position where the venture is of low risk. In situations where investments are excessively positive or excessively negative, then leverage should be reduced so as to focus on profits. However, in the United States, this was not what occurred in 2008. At that time, investors traded in securities that depended on the housing boom. These securities were high risk because their prices were not regulated. It can therefore be argued that most banks disregarded market fundamentals at a time when there was intense euphoria. After the excitement died down, most banks became stranded as they were highly leveraged and they had to hold onto their securities (which were falling rapidly) or they began selling them at losses because their value had gone down. Consequently, many influential banks went bankrupt and had to close down. The business that they brought to the US economy and the world as well also went under. This meant that international traders were affected thus leading to the global recession (Sweezy, p. 39).
Securitization of mortgages refers to the process by which mortgage loans from small lenders are accumulated and then sold to larger institutions which then package them into a financial instrument known as the mortgage security. This is a means against which homeowners can then pass their payments to investors. However, the major shortfall in securitization of mortgages occurred when homeowners have low credit ratings i.e. subprime borrowers. This is because at the beginning of their investments, interest rates were very low but these eventually increased. Ultimately, borrowers became overwhelmed with the soaring interest rates thus leading to foreclosures. Banks were stuck with securitized mortgages that had no value as homeowners had not met their end of the bargain. Lending institutions could not continue lending because of such securities and consumers couldn’t borrow; this meant cutting down on expenditure. Companies could not produce because consumers were not willing to buy as much and this led to the economic crisis (Meyerson, p. 7).
Toxic assets refer to those risky ventures linked to the mortgage market. In essence banks that possess toxic assets have negative balance sheets as a result of basing their assessments on defaulted mortgage-backed securities. This means that lenders cannot trade with one another and they cannot also offer the same to the public thus leading to a vicious cycle that was the US economic crisis.
Conclusion
The US economy plunged downwards because of a lack of adherence to market fundamentals which could have easily eliminated this problem.
References
- Meyerson, Harold. “Building better capitalism.” Washington Post. 2009: 7
- Orhangi, Onesmus. Financialization in the US economy. New York: Edward Elagar Publishers, 2009
- Sweezy, Paul. Economic Reminiscences. Oxford: Oxford University Press, 2008