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The current economic crisis that started in the year 2007 is considered by many experts in the financial experts to be the worst financial crisis since the Great Depression of the 1930's. Among the casualties of this crisis were large financial institutions; many of which collapsed due to the gravity of the crisis. Banks too were not spared and had to be bailed out by national governments; stock markets around the world experienced downturns. This crisis was actually triggered by a liquidity crisis in the banking system of the United States. This Essay seeks to discuss the subprime mortgage crisis that came about during the economic crisis.
The Subprime Mortgage Crisis:
The subprime mortgage crisis was one of the earliest indicators of the financial crisis. It was characterized by a rise in foreclosures and a consequent decline in securities that backed these mortgages. The people who had increased their wealth substantially as a result of the run up of the prices of stock increased their spending substantially. The wealth realized from the stocks resulted in the buying of new homes that were bigger and better for they wanted to spend a substantial amount of their new stock wealth on housing. House rents rose by less than 10%, this was enough evidence that the country was experiencing a housing bubble. If the course of the housing bubble would have taken the same path as in Japan, the housing bubbled would have collapsed alongside the stock bubble between the year 2000 to 2002. On the contrary, the stock bubble collapse in fact helped to fuel the housing bubble. This was because millions of people lost faith in the stock market and saw real estate as a safe alternative investment avenue (Baker, Dean page 72-73)
As a result of the dot com bubble burst in early 2000, the American economy was at risk of recession. The terrorist attacks on the 11th of September the following year further compounded this situation. In a bid to stimulate the economy, central banks tried to stimulate growth by creating capital liquidity by means of a reduction in interest rates. Everyone involved in the housing sector including mortgage lenders, regulators, homebuyers, rating agencies, investment and central bankers erroneously thought that the ordinary rules of finance and economics no longer applied. The bursting of the tech stock bubble a few years before did not serve as a lesson for the soaring housing market; the players in this sector thought that things were truly different. Prices of houses shot up faster than household incomes or rents, in the same way the dot com era stock prices had risen leaving corporate earnings far behind. Markets were convinced that prices of houses, unlike those of stocks could sky rocket without later falling back to earth the way that NASDAQ and the Dow had (Zandi,Mark,M. page 5-6)
The rising house prices made many people to want a piece of the benefits. Though many of these people were forthright and prudent, a good number were not. Home buyers and lenders, either implicitly or explicitly conspired to fudge and even lie on loan applications only thinking about the appreciating property values. Homeowners believed that the rise in the prices of houses would enable them to refinance again and again, thereby freeing cash while at the same time keeping mortgage payments low. To the lenders, this meant more fees. The surging home values empowered investment bankers to invent increasingly sophisticated and complex securities that ensured that money kept flowing into the fast growing housing markets.
Houses were traded like stocks; they were bought and sold purely on speculation that the prices would continue to soar. In seeking greater returns, lenders took greater risks by approving loans to borrowers with poor credit. Builders made the wrong calculation in estimating the number of potential buyers for their new homes. In the end many of the mistakes made in the tech stock bubble were replicated in the housing bubble, thereby resulting in a bust and crash. The housing sector found itself in a vicious cycle whereby the prices of houses declined, leading to defaults in payments and finally resulting in foreclosures. (Zandi,Mark,M. page 5-6)
A solution to the financial crisis: Stabilize the Financial Sector
One solution of the financial crisis is to stabilize the financial system because no modern economy can survive a meltdown of its financial sector. The financial sector can be recapitalized by transferring wealth from the tax payers to banks and brokers. The American government through the Paulson Plan did this by buying assets at above market prices. Another solution would be to close weakening or defunct, this would be done under the new bankruptcy regulation through which the courts would act with extraordinary speed and authority. This should include the replacement of top level managers who should be replaced by managers selected by a bi-partisan committee of business executives and should have a minority of members from the financial industry. Outright nationalization as it was done to the defunct Savings and Loans during the early 1990's and presently with AIG is also another option, after their acquisition they should be operationalized and eventually be privatized. The creation of an agency similar to the depression era Home Owners Loan Corporation can play a key role in the application of these policies (Maximus, Fabius).
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Stabilize the Financial System
This can be done by better equipping the country's human resource setting up training and education programmes since there will be many unemployed people and this would be a perfect opportunity for them to upgrade their skills for the net cycle. Many local governments such as New York City therefore the government should work with the States in order to prepare the relevant financial and legal apparatus. It might also be necessary to implement a monetary stimulus package such as it was taken by Japan after the 1989 crash. These loans have near zero interest rates that are far below the rate of inflation which translates to an increase in the Federal Reserve's balance sheet (Maximus, Fabius)
Arrange long-term financing with foreign creditors
It involves negotiated agreements with foreign central banks who are the primary creditors of the United States; this can only be done with the support of Congress. The government will need to reschedule our debt and source for new financing and steps have to be taken to stabilize the value of the U.S dollar so as to allow an orderly decline. These negotiations will put into question America's role as a global hegemon and more importantly the US Dollar's role as a reserve currency. The United States will have to make concessions (Maximus, Fabius)
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Economic Crisis: Past lessons, future policies
According to estimates from the World Bank, slower economic growth as a result of the economic crisis will trap about 46 million more people than was earlier expected, to live on less than 1.25 US Dollars a day. Moreover, another 53 million people will be pushed to live on less than 2 US dollars a day. Given experiences from previous crises, governments need to consider the impact that the financial crisis will have on children. In developing countries for instance, there will be an increase in child mortality, a decline in school attendance, child labor and exploitation, violence against women and children, nuture, care and general emotional well being.
All these can be traced to times of economic hardships. Vulnerability depends on gender and age and is multidimensional. The poorest families are the most vulnerable. Women are usually the first to loose their jobs, this forces them to work harder in their attempt to seek additional income hence they spend less time in the nurturing and caring for their children Policy makers should not underestimate households, including children when formulating policies in response to the economic crisis. In order to limit child poverty, food, health and education together with the availability of safe drinking water and the protection of these children against neglect and violence need to be emphasized. (Harper,Caroline, et al page 1-2)
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The economic crisis that came about in the late 2000's that had its roots in the United States took its fair share of casualties from banks and other financial institutions to ordinary citizens who suffered the brunt of massive lay offs. Many investors also lost out on their investments, especially those that had invested in real estate. Players in the housing sector al share the blame because they abandoned their morals all in pursuit of profits to the extent that some even lied in their mortgage application. The economic crisis should serve as a lesson that the ordinary rule of finance and economics will always apply. There is also an urgent need for the Federal Government to work hand in hand with the relevant States to prepare the necessary legal and monetary apparatus early enough in order to protect vulnerable local governments from the ravages of the economic crisis. The crisis has slightly eroded the edge the United States had over the rest of the world and any crisis of such a magnitude needs to be avoided under all circumstances.