Recently, I just finished reading “The Map And The Territory: Risk, Human Nature and the Future of Forecasting” by Alan Greenspan, who served as the Chairman of the Federal Reserve of the United States from 1987-2006 and was struck by his succinct explanation of the factors leading up to the disaster.(It is an excellent book btw, HIGHLY RECOMMENDED if you are an Economics enthusiast like I am).
As with all Economic problems, one has to look beyond the surface of evil bankers and large banks to understand the complexity of the issue and the contribution made by different parties that culminated into a large housing bubble. In this 3-part special, we will give a short and brief analysis of the micro and macro reasons that resulted in the crash.
A crisis of historic proportions
The financial crisis that struck the world beginning from the summer of 2007 is without precedent in economic history. Although its size and global impact was exceptional, it had many features that were common among other historic financial crisis. It was preceded by long periods of credit growth, low risk premiums, abundance of liquidity, strong leveraging, soaring asset prices and the creation of a massive bubble, this time in the real estate industry. Financial Institutions(Banks) overly leveraged profile resulted in their vulnerability to even small dips in the mortgage industry.
Though the crisis fully exploded towards the summer of 2007, cracks in the real estate industry were emerging by 2006, the market has been expanding over too long and space capacity was bound to emerge. There was a clear detection of over-confidence as housing prices, historically averaged around USD 150,000-200,000 but by the end of 2006 were reaching nearly USD 350,000
In its early stages, the crisis manifested itself merely as a liquidity shortage among financial institutions as mortgage defaults resulted in increased difficulty to clear their short-term debt as confidence declined. While there were increasing concerns over the solvency of banks, there were still no clear signs of systematic default. However, this perception dramatically changed after the bankruptcy of a major US investment bank, Lehman Brothers, (may have been a mistake to allow the bank to default).
From then on, there was massive market panic. Confidence plummeted, investors and financial institutions fire-sell their assets, regardless of price, to acquire liquidity which was deemed to be the safest and the stock market went into a massive downward spiral. This further depressed asset prices thus further endangering investors and banks which thus culminated into a dangerous feedback loop.
Banks distrusted one another and refused to lend which further sapped liquidity from the market. Business investment and consumer demand nose-dived and the massive layoffs were only a matter of time. Many swarmed to banks to retrieve their savings and a bank run was in way.
While the massive panic was eventually stopped, the damage has been done. Unemployment rates will eventually soar from 4% to nearly 10%.
The whole world was affected but it was the advanced economies that were hit the hardest due to their exposure to the financial sector.
In the next series of posts, we will aim to explain the factors contributing to this massive crisis.
Check out Part 2.….