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How the financial bubble burst
Al Jazeera's Rob Reynolds examines the roots behind a week of global financial turmoil.
Last Modified: 25 Sep 2008 04:10 GMT
Are more US financial houses about to come crashing down? [AFP]

The roots of the panic in financial markets around the world are deep and complex but they lie in the convergence of three factors.

Millions of people pursuing the "American dream" of home ownership, politicians and regulators who dismantled a system of financial safeguards and then ignored warnings of impending disaster, and financial markets and institutions disregarding risk in their headlong pursuit of profit.

Let's go back to the beginning - or at least to the year 2000 - when the 'Dotcom' boom went bust.

That drove down stocks and sparked a recession and then came the attacks of September 11, 2001 - a body blow to the US economy.

To hasten economic recovery, the US central bank, the Federal Reserve, headed by Alan Greenspan, used the most powerful weapon in its arsenal - it cut interest rates repeatedly.

Lower rates made it easier for banks to lend and consumers to borrow and spend.

"It did stimulate the economy," says Clyde Prestowitz, the head of the Economic Strategy Institute.

"And it stimulated housing, because effectively the cost of investment was negative, you could borrow money for virtually nothing."

Easy borrowing

Home-ownership is the bedrock of the "American dream".

US tax laws encourage home ownership by allowing people to deduct the interest they pay on their mortgages.

Freddie Mac underwrote thousands of
US mortgages during the boom [AFP]
And government-sponsored financial institutions such as Fannie Mae and Freddie Mac contributed by underwriting mortgages and making it easier for people of modest means to put down the money for a home.

From around 2001 and 2002, with mortgage interest rates at near-record lows, millions of Americans went shopping for homes.

With demand soaring, the price of housing nearly doubled from 2000 to 2006.

But many of those buyers couldn't really afford what they were getting, Prestowitz says. 

"They wanted to buy a house and it's understandable, they wanted a piece of the dream and the mortgage industry was encouraging them to buy.

"It got to the point where the brokers were offering mortgages to people who had little or no income, who somehow thought they could put these payments together."

Sensing a potential bonanza, banks and mortgage companies began peddling loans to riskier segments of the population - especially low-income first-time homebuyers.

These were called "sub-prime" mortgages.

"Many of the mortgages were adjustable-rate mortgages," Prestowitz explains.

"They were built so that in the first year your interest rate was low, but somewhere down the road, your interest rate jumped."

Ideological drive

But something else was at work as the housing bubble grew: The US government, under the sway of the free-market, anti-regulation ideology, had begun to systematically dismantle rules and regulations established after the Great Depression of the 1930s.

In 1999, the US congress and Bill Clinton, the former president, repealed laws designed to stop financial crashes - saying markets should regulate themselves.

Government regulation, we've been told, is bad, it's evil, and the government doesn't know what it's doing economically.

Lawrence Mitchell, financial analyst and author

Why?

Lawrence Mitchell, the author of The Speculation Economy: How Finance Triumphed Over Industry says it was the triumph of ideology over caution.

"Since Ronald Reagan became president in 1980, free markets have been preached in this country as being our economic salvation," Mitchell says.

"'Government regulation' we've been told, 'is bad, it's evil, and the government doesn't know what it's doing economically'."

"'It should be out of people's business'. That's nonsense, but that was the ideology that was driving it. 'Regulation is bad, free market is good'."

The next president after Clinton, George Bush, continued to de-regulate housing and financial markets and bragged about the results at the 2004 Republican convention, saying: "Another priority for a new term is to build an ownership society, because ownership brings security and dignity and independence.

"Thanks to our policies, homeownership in America is at an all-time high."

Mortgages sold

Of course, it  wasn't just the politicians who allowed the reckless financial frenzy to grow. It was also the man who the financial press was hailing as a genius -  Alan Greenspan.

Alan Greenspan has been blamed for
deregulating markets [AFP]
"The Fed is responsible for oversight of the banking system, but under Alan Greenspan it basically stopped doing oversight," Prestowitz says.

"That allowed for fraudulent practices and, as a result mortgages being given to people who had no assets and no income, prudent lending went out of the window."

In the new, hands-off regulatory environment, banks and mortgage companies transformed the loans they were making into commodities.

The change was the banks no longer held the mortgages and the home finance industry began to securitise, or underwrite, them.

In the past, when you would buy a house, you would get a mortgage from your bank.

The bank would hold that mortgage and you would pay it off, with interest.

Today, you get the mortgage from your bank and the bank immediately sells your mortgage to Goldman Sachs or Lehman Brothers, or Deutsche Bank or any of literally tens of thousands of mutual funds, hedge funds, pension funds, or private-equity firms.

Those pools of mortgages are then bundled together into securities, just like bonds or stocks.

Millions of securitised loans were sold to firms all over the world.

At first it was a lucrative deal with high returns and little apparent risk.

The bubble bursts

But there was a worm in Wall Street's apple: Millions of the mortgages being sold -  more than 20 per cent at the peak of the frenzy - were high-risk "sub-prime" loans.

"What was happening was a lot of bad stuff was being mixed with good stuff and it was being called good," Prestowitz says.

Thousands of homes have been
foreclosed [GALLO/GETTY]
The global financial community seemed to believe housing prices would just keep going up and up but then the bubble burst.

The Federal Reserve began raising rates to fend off inflation.

As the rates rose, people who had taken on balloon-style mortgages - thinking they could easily pay the initial rate - found their payments being increased and suddenly ... they couldn't pay.

In 2006 home prices started to drop. Houses glutted the market and stayed unsold month after month.

In formerly red-hot housing markets, like Florida and California, home prices fell 10, 15, even 20 per cent. A huge wave of loan defaults and home foreclosures began.

In 2007, mortgage lenders with lots of risky loans on their books started going bankrupt.

Then major investment banks came under pressure and began to fail. In March, Bear Stearns was the first of the majors to go under.

The problem then was not, and is not now, about houses. It's about credit - or the lack of it.

With so much bad debt out there - and no one really knows how much there is - banks around the world have become extremely risk-averse.

They've stopped lending money to individuals, businesses and even each other.

Unable to get loans, Lehman Brothers, the fourth-largest US investment bank, went belly up.

Central banks have by now pumped hundreds of billions of dollars into the global financial system, but the flow of credit, known as liquidity, has slowed to a sluggish trickle.

Bleak future

For the first time since the 1930s, a true, systemic financial crisis is under way. 

That's why the US government is considering sweeping and costly measures to buy up millions of bad mortgages.

But while the plans announced late this week seem to have boosted confidence on Wall Street, no one really knows what will happen next.

"It could get a lot worse, said Mitchell, gloomily.

"I haven't read any significant empirical evidence to suggest we are anywhere near the bottom."

"Where's the bottom?" I asked him.

He replied: "The bottom could be very deep.

"I really don't want to know."

Source:
Al Jazeera
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