Dear “homo economicus”, you have been told of an ongoing financial crisis, some economists even spoke about recession, but do you have any idea of what is making the guys in the stock exchanges so worry about the future?
I propose you a travel in time around three simple questions for a better understanding of what they call the financial crisis.
- Where did it all begin?
All began in the offices of the mortgage brokers in the United States in the early 21st century. Those guys, proposed loans to people who are usually not given any investment possibilities. Thus, access to property was offered to a larger part of the American population, although many borrowers were in a risk group. This is because, in the past, they possibly had trouble paying their rent, or had been unemployed for a while. So, the mortgage broker was charging them a so-called “subprime”. Moreover, the loan was secured by real property through a legal instrument called mortgage. The latter corresponds to the use of a real good, in our example houses, as a collateral for a loan, that is to say in case the borrower cannot repay the loan the house will be sold by the lender to recover its money.
Hence, more people came on the market for houses, increasing the demand and increasing the prices. Now, remember the goods were secured by a mortgage; so the increase in prices was seen in a good way by mortgage brokers, making their business safer. That was true as long as the prices of houses continue to increase and the interest rate was kept low. But like most of economic assumptions, at the end it does not work. Indeed the prices went down after the bursting of the United States housing bubble and the interest rates rose. A part of the borrowers could not face the increase in monthly payment, and their houses securing the loan were now worth less than the money borrowed. Consequently, the mortgage brokers could not repay themselves. As a direct effect, some of those companies went bankrupt and were unable to repay the banks they were working with. We have seen how emerged the so-called subprime crisis.
- How did that affect the world financial market?
The subprime crisis in the United States affected the world financial market through what one calls the process of securitization. Remember, we have seen that the loans offered by the mortgage brokers support a risk. But it exists a way of transferring the risk, by creating a debt security and to sell it to an investor. A debt security can be seen as a portfolio inside of which you pool together any asset producing a cash flow, in our example loans, which will give to the owner of the portfolio every month a payment, actually the monthly payment of our borrowers. The debt securities, created by the American brokers have been spread world wide, bought by investment funds. Thereby, when the subprime crisis affected the USA, the effects have been diffused in the world financial market, because financial actors all around the world supported the risks. You now understand why Fortis went almost bankrupt, if you are Belgian, or why Northern Rock has been nationalized, if you are British, because those banks got debt securities made of mortgage loans, or because they lent money to investors who have been attracted by the potential high return of those securities.
- What are the possible consequences for the real economy?
It is not absurd to consider that the financial crisis will affect the real economy. Indeed the difficulties of the banks, even sustained by the governments and other financial institutions, such as the European Central Bank or the US Federal Reserve, have already impacted on the household confidence, reducing the consumption, as well as the investment. Thus, we entered in a period of reduced economic activity, the question is now if that period will last enough to be called a recession?
Sébastien
