When Good Things Go Bad

When Good Things Go Bad

 It all started with the generous help from the government to boost economic activity; reasonable reasons for saving to cushion from the economic uncertainties; and fulfilling the dreams of millions of Americans. But all of these nice things led to the shocking global financial crisis in 2008. So what, then, are the ingredients to turn good intentions to reasons that spoil the once-before appealing world economy?

The credit crunch of 2008 was caused by a lot of factors. And the baking of the financial collapse began by adding a teaspoonful of US economic recession and a dose of savings glut in a bowl of heightened economic uncertainties. Mix these two together, the global economy created the first flavor of the crisis - the low interest rates. The US economy suffered a mild recession back in 2001, following the end of the dot-com boom and the resulting decline in stock prices because of various geopolitical uncertainties associated with the terrorist attacks of 9/11. These events led to the slowdown of economic activities within the US – businesses slashed investment spending, reduced demand for labor which led to increased rates of unemployment. In order to remedy the slowdown of economic activity and boost the US economy, the Federal Reserve lowered interest rates. Low and declining interest rates encouraged household spending particularly in the housing markets and more investments in home construction.

Moreover, the heightened uncertainty and shaken confidence because of the current economic conditions and terrorist attacks, resulted to an increase in the global savings rate. Probably a consequent reaction from the 1997 Asian Financial Crisis, a “savings glut” in the emerging economies in Asia and oil-producing countries, especially China, emerged. Together with the increase in corporate savings around the world, the surfeit of savings over investment flooded into safe American treasury bonds, further driving down long-term interest rates.

As mentioned earlier, these sweet-flavored low interest rates encouraged household spending in the housing market. Thus, a housing bubble formed. With an added ounce of social objective of increasing minority homeownership rates, government officials further encouraged banks and mortgage lenders to lend more to minorities and the poor, relaxing their lending criteria. Enticed by the sweet flavor of the booming real estate market and fueled by the lax requirements to issue loans, banks and mortgage salesman, who are paid on commission, actively issued NINJA loans. Without understanding what they were actually offered but allured by the aroma of cheap money in the form of low interest rates, many individuals took these adjustable rate mortgages. The subprime mortgage market expanded very quickly.

Banks, mortgage lenders and investors alike had a feast with the housing boom. To further profit from these rather very risky mortgages, banks pooled them into collateralized debt obligations (CDOs) and passed them on to other banks and financial institutions. These “safer” tranches were bought by investors because rating agencies gave them triple-A credit ratings. These CDOs were also sought out by investors because they appeared to be relatively safe while providing higher returns in a world of low interest rates. However, this credit ratings were coated and glazed by bias and imperfect information. In a world of asymmetric information, credit rating agencies took advantage of their power of being relied upon by investors and the public in general to give objective, accurate opinions to resolve the hidden information problem of the market. But because banks and mortgage lenders pay these agencies fees to rate their securities, the actual ratings were either wrong or downright very wrong. Add to this a pint of irresponsibility and negligence on the part of regulators who declined to fully use their authority to check and correct the enthusiasm of the financial intermediaries, the economy was deemed to collapse.

When we add a dose of inflationary pressures in the economy, which caused interest rates to rise as what happened in 2006, adjustable rate mortgage payments became more and more unaffordable for borrowers. As mortgage defaults increased, the housing bubble finally burst. House prices started falling which was exacerbated by the increase in building new homes during that period. It meant that demand for housing fell as supply was increasing, causing prices to collapse in a drastic way. Moreover, when the housing market began to decline, many banks and financial institutions around the world lost a lot of money leading to a deterioration in their balance sheets. This in effect led to trust issues in the financial system.

Breaking the one crucial link in the financial industry - trust - further aggravated the collapse of the economy. This caused the freezing of the money market because banks won’t lend to other banks and investors are not confident anymore to trust these institutions of their money.  Adding this drop of trust problems to the mix of an already spoiling economy, the financial crisis is almost ready to be served.

The cake is not complete without its bittersweet filling – one composed of self-interests and a lot of unethical behaviour associated with it. Everything would not have happened if the financial intermediaries, credit rating, and regulatory agencies have just performed according to what will be good for the entire economy, and not according to what will make them richer and richer through the early stages of the bubble. What happened was a series of unethical events that were covered up by similar incidents from involved people – financial institutions taking advantage of the citizens’ vulnerability in order to gain profit by relaxing standards in giving out loans and capitalized on doing so since such profits are based on commissions; SEC not using their authority to regulate the market and thus probably able to address the voracity of the financial intermediaries; and credit rating agencies covering up the devaluation of these instruments by keeping their ratings at a high level just to keep up with competition, among others. These individuals were enticed and blinded by the promise of having considerable profits each instance they engaged in a transaction that would further enlarge the credit bubble, without regard to what its possible aftertaste would be to concerned citizens.