Causes of the Financial Crisis Essay Example | Topics and Well Written Essays - 1250 words

Causes of the Financial Crisis - Essay Example The analysis takes a global outlook to examine the various issues connected with the financial turmoil which is believed to be begun as a result of U S mortgage crisis. There are divergent opinions as to what caused this global phenomenon that resulted in the ravage and meltdown of stock markets in almost all countries. The present chapter, however, throws lights on the reasons that are generally believed to have contributed to the most distressed global crisis The US originated crisis started late in the 20th century became acute in 2007 from the US subprime lending market like a distant tornado. More than two million homes financed by subprime lenders were expected to face foreclosure in the period of crisis and nearly 17% of subprime mortgages issued so far were projected to fail (Center for Responsible Lending). The roots of the current US subprime lending crisis can be traced back to the spiraling housing prices in the first half of this decade. Extremely low lending and borrowing rates increased the demand and supply of existing and new houses. Several institutions started offering subprime mortgages, to borrowers who had unfavorable credit history, at lower than normal repayment interest levels with little or no down payments. Many investment banks and hedge fund owners began to bet on this new aspect of the US economy. This had allowed investors to avail themselves of loans at low interest rates and invest them in higher yielding a venues. But soon with the US Central Bank (Federal Reserve) initiating a series of interest rate hikes leading to the increase of cost of borrowing to 5.25%, which is the maximum since the last half a decade, and a simultaneous decrease in housing prices, the subprime mortgages were reset at high rates leaving the borrowers to foreclose their accounts and miss payments (Lawrence 2000). As an outcome, financial institutions and banks with mortgage securities incurred huge losses and had to trade their assets leading to subprime lending crisis. Even though "Countrywide Financial", the biggest mortgage lender in the US, managed to withstand this crisis owing to the diversification in writing of the loans, other big players like New Century Financial, DR Horton, Weyerhaeuser and American Home Mortgage are all reeling under its impact (Kenneth 1990). 2. Low Inflation For 15 years the US economy had long and continuous economic expansion with low inflation. The US economy was following an expansionary monetary and fiscal policy. There was excess liquidity in the economy. During this period, the rate of interest was very low and there was a housing sector boom. During this good time, financial institutions, particularly investment banks showed a lot of interest in providing housing loan. They took heavy risk and made huge profits. High profits encouraged the banks to take higher risk. High leveraged transaction with life covenant became the norm. They started providing loan to prime as well as subprime borrowers though the borrowers did not have the capacity to repay the loan if the interest rate would go up. Loans were given on the assumption that housing prices always would go up and in the initial stage; borrowers were charged lower interest rate. 3. Fall of Major Investment Banks and Financial Institutions The