What caused the economic crisis?
A number of contributing factors have led to the current economic crisis that we face. I will list three of the major factors.
1) U.S. Housing Bubble – From 1999 – 2006, home prices in the US rose at a rate that was not sustainable and property valuations appreciated much greater than income levels. During this time period of “easy money”, lenders were giving loans to unqualified borrowers. These borrowers had below average credit scores and low income levels. Also, predatory lenders were taking advantage of these sub-prime borrowers by giving them high fee adjustable rate mortgages that would reset to double digit interest rates. These bad loans were then packaged together and sold to banks, businesses and investors as mortgage backed securities.
2) Credit Crunch – American consumers relied heavily on debt as a way of financing their purchases. Too many people treated their homes like an ATM and would refinance it whenever they needed money. As home prices declined, borrowers were unable to take money out of their homes. This led to a rise in the number of homes that went into foreclosure.
3) Liquidity Crisis- Wall Street investment banks and U.S. banks relied too much on leverage. For every dollar of cash that an institution had, they would borrow 40 times that. As more and more homes were foreclosed, the value of the existing mortgage backed securities owned by financial institutions declined. This caused a liquidity crunch for these institutions where they needed cash but had no means of obtaining it. The availability of credit shrank and the cost of obtaining credit skyrocketed. Banks were scared to lend to banks. Businesses that rely heavily on loans to fund operating activities were unable to obtain financing.
Other factors such as credit default swaps, derivatives, easy money policy from the Fed and high commodity prices also placed a part. All of these issues led to business bankruptcies, rising unemployment, major stock market decline and the delevering of financial institutions.
