Recession 2008: Origin (part I)

The formation of bubble of the present economic crisis dates back to decades earlier where a combination of factors contributed to its materialization. The lack of prudent risk management procedures by financial institutions, massive proliferation of new financial instruments and serious recklessness in government regulation are the major causes that helped promote continuous expansion of the bubble. On top of all these, people’s house price expectations- that it wouldn’t fall but grow all the time- also incessantly provided fuel for propagation of crisis over the years. The bubble couldn’t sustain the growing pressure and had to burst finally in August 2007.

Financial institutions exposed to higher risk when they started lending lower quality loans. The exponential growth of subprime lending during the time demonstrates their reckless lending behavior. With an expectation to increase in house prices in the future, lenders continued to lure subprime borrowers offering attractive-but-financially-unsustainable schemes leading to unwholesome home purchases. No down payment and subsuming of interest on principal if failed to pay installment are some examples of such practices that were abundant during the time.

Coupled with such attractive plans, the so-called securitization of loan by issuing mortgage-backed-securities played substantial role to inflate the bubble. With these techniques, the mortgage loan became accessible to vast majority of people who might have ever dreamed of buying homes. Freddie Mac was the inventor of such financial instruments issuing it first in June 1983. Fannie Mae and Freddie Mac, both government institutions, were engaged in this business to provide guarantee for conforming loans, but later private enterprises also entered into the market with different innovative financial instruments at hand providing guarantees even for non-conforming loans. This raised risk in the entire financial system at a substantial level.

Beside all this, lower interest rates due to adoption of easy monetary policy also helped increase demand for homes and thereby home prices.

While financial institutions borrowed money ceaselessly to purchase mortgage-related securities, which is normal during boom in asset prices, the proper regulation of growing mortgage market was in dire lack. With increased borrowing, banks continuously rolled over their balance sheet portfolio without caring much on the risk that this can create. In the chain of securitization, the risk was continuously passed off to other party with little worry to do in each stage. In such tenuous system, when there was uncertainty over asset prices the lenders refused to roll over debts, then the assets of some banks fell short of capital, and finally the crisis exploded.