Nowadays, the words “downturn”, and “crisis” are synonymous with the world economy. People have become immune to hearing about the declining financial system. Every other news channel, firm, and person is talking about the credit crunch and affiliated problems such as the slashing of numerous jobs, shrinking in total output etc. But how much does the average person know about the problem- apart from the superficial association of it with the words ‘downturn’ and ‘crisis’. The term recession is defined as the decline of economic activity which is evident in real economic growth, employment levels, and industrial production. It is important to note that the general decline was not due to a widespread flaw in the economy, rather it stemmed from a few root causes namely, the US housing market and the subprime mortgage crisis [which was caused by financial instruments i.e. mortgage backed securities (MBS) and collaterized debt obligations (CDO) .]
A Mortgage Backed Security is a bond that is backed by a pool of mortgages that are being paid by homeowners across the United States. These are bought by the investors from the lenders who see it as a insured alternative. The lenders basically sell the loan off to the investors who pay them right them in exchange for the bond. When an investor buys a bond, they are essentially buying the cash flow from different homeowners as they make their monthly mortgage payments. If a homeowner defaults on their mortgage or misses a payment, the MBS holder suffers. A CDO is a way that some investors, such as banks tried to evade the risk of buying these mortgage backed securities. Think of this as a MBS on steroids; instead of one investor owning the cash flow of a mortgage – multiple investors could own it. The investors tried to take out insurance that the mortgage-backed security wouldn’t default, with the CDO paying off if the MBS didn’t. The investment banks bought CDOs from the insurance brokers, such as AIG, who saw the investments as fairly risk-free because as long as the housing market kept going up, any borrower who defaulted on their loan could simply give the home back to the mortgage holder, who would re-sell it, getting at least the money owed for it, if not more. Thus the credit received by the MBS holders would be maintained or increased, depending on the mortgage payments.
The meltdown began because the original lenders were selling mortgages to large investment banks and so did not particularly care how credit-worthy the people taking the loans out were. They started offering these mortgages to less credit-worthy borrowers, otherwise known as sub-prime borrowers. (Government policies such as low interest rates also encouraged higher risk lending practices several years prior to the crisis.)
Subprime lending is a term that involves financial institutions lending to borrowers who are less likely to pay the money back, such as those with a recorded bankruptcy, high debt-to-income ratio, lack of income documentation or limited debt experience. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. The subprime mortgage crisis was triggered by a dramatic rise in mortgage delinquencies (inability to pay debt) and foreclosures in the United States. A foreclosure is a legal proceeding in which a lender obtains a court ordered termination of a borrower’s equitable right of redemption. Before receiving the mortgage loan the borrower must pledge an asset such as his house to the lender to secure the loan. If the borrower defaults (becomes delinquent or does not pay on time), the lender can try to repossess the asset but courts grant the borrower the right of redemption if he repays the debt within an allotted period of time. However due to uncertainty of repayment, the lender seeks to foreclose the right of redemption (in other words seize the property and sell it). Now this doesn’t seem that bad for the lender as he is still able to sell the property and make a profit.
The credit crisis arose when US house prices started to fall after the bursting of the housing bubble in 2006-07. Thus many homeowners (subprime borrowers) who defaulted were in a position of negative equity- a mortgage debt higher than the value of their property. Since the repossessed houses were sold for less than the debt owned on them, lenders had to call in banks such as AIG as reinsurers to cover their losses which were too great even for these major banks leading to a significant tightening of credit around the world. This has had a profound impact on MBS and CDO investors who also saw their credit decline as sub prime mortgage payments declined. A major consequence of all this is a close integration of the US housing markets with the global financial markets which stimulated a worldwide recession.
The causes of this recession can thus be summed up as factors stemming from both the credit and housing market. The fall in housing prices, inability of homeowners to make their mortgage payments and monetary policy (increased interest rates) all contributed to different degrees to the current credit crunch which initiated a domino effect- People cut their expenditure hence businesses produced less due to fall in demand. To keep costs minimum and maintain profit as revenue fell, they also started laying off workers (wage bills went down). The unemployment levels drastically rose which caused people to spend even less and thus began a global chain of economic uncertainty and ‘downturn’.