Nature of the Sub-Prime Crisis and Micro and Macro Causes

Nature of the sub-prime crisis and micro and macro causes

Peter (2009) said ‘one of the defining features of the subprime crisis is to see it as a natural outgrowth of a policy of utilising both public funds and regulatory pressure to increase home ownership’. Actually, throughout the history, the sub-prime crisis of 2007-09 is a process from expansion of credit to credit crunch. Before 2004, many people in the America borrow loans to buy houses in order to invest. Although banks don't have enough deposit to loan, they still use other ways to get money and offer to lenders. However from 2004 to 2006, the US interest rate rose from 1% to 5.35% (BBC 2009). Then the house investment market start to atrophy, the house price reduced and the householders, especially those short-term speculators didn't have enough money to repay the loan, even they sell the house. Because, in the initial, these arbitrageurs just want to borrow the money to buy the house and sell the house when the price grow. Thus, a lot of bad debts appeared in banks following by the low liquidity. Finally, the sub-prime crisis broke out.

Throughout the whole history of the sub-prime, one of the macro causes is Global Financial Imbalances. From the 1970s, American government started to implement neo-liberal economic policy (Maxine 2002). Actually, this policy is obviously good in the initial time; it enhanced the economic efficiency and pushed faster economic growth. However, due to the deepening of reforms of economic policies, banks start to change their asset structure to get higher profit without any constraint. Due to the rise of subprime loan market and the mortgage bond market in the past five years (BBC 2007), the wholesale finance models rose with low restriction. Banks extensive used mortgage bond to lend funds and transfer them to off-balance sheet assets to create higher liquidity. Therefore, the global finance started to imbalance finally. Another important macro cause is long period of low real interest rate, BBC (2009) report the American interest rate was keeping about 1% for a long period before 2004. Due to this reason, many private investors start to invest their funds into housing market, thus the house price rose at that time. Then a large amount of people influx into the housing market through sub-prime loan, until the house price fall down in 2007. Finally, the property market crashed, many people can’t repay loan and banks went bankrupt due to the bad debt.

According to above, the micro causes can be find and research from macro reasons. So, why so many people influx into the property market, because, the house price rose rapidly and consumer inertia. At that time, many people use sub-prime loan to buy a house, they are actually speculators, because they don't have enough assets for repayment. They just want to get arbitrage from the house market. As we know, these people shouldn't get and bank loan from traditional-prime model, because, their credit level is not enough. However, the sub-prime market can offer the loan to these low credit people. At that time, Americans believed their risk measurement technique and regulation. They always violate the prudential regulation to use the risk measurement technique, such as MBS and CDOs. Because many banks, especially, investment banks didn't implement the Basel due to the neo-liberal economic policy. They use MBS and CDOs to put their loans into an assets pool and mixed different risk loans to make assets securitization and increase the rating level from rating agencies. Then banks push their mortgage bonds to the market and sell to the world wide investors. It seems a perfect plan to create arbitrage for banks. But don't forget, all of the above are based on the growth of house market. Jens, Peter and David (2011) said one of the reasons of sub-prime is the low mortgage bond liquidity. Due to the house market crashed, banks can’t receive the money on time, people or investment organisations that hold the mortgage bonds will start to massive sell-off their bonds. Then the bond market crashed. As the result, the liquidity of bonds had a sharp decline. Right now, the defect of MBS and CDOs appeared. These two techniques use the high level of corporate leverage to offer the higher bonds interest rate than other investment market. However, if the market crashed and too many people start to sell-off their bonds, banks will face the huge amount of losing due to the high leverage also. They can’t prepare enough cash for the bond redemption. Therefore, banks’ assets liquidity will be not enough to keep them running and finally get bankrupt. The sub-prime crisis happened formally.

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