The housing market became flooded with homes for sale, because the homeowners with variable rates and interest only loans could not continue to make their payments. (Greenspan) The rise in the number of homes for sale caused further lowering of home values. Keeping in mind that the main reason for the mortgage crisis is the high number of defaulted home loans, which triggered foreclosures and sell offs. The other four contributing factors include high-risk loans, the bust in the housing market, mortgage fraud, and speculation. High-risk loans are loans that are over leveraged, where the financing is done more than the suggested values to be given.
The bubble forced banks to give out homes loans with unreasonably high risk rates. The response of the banks caused a decline in the amount of houses purchased and “a crisis involving mortgage loans and the financial securities built on them” (McConnell, 2012 p.479). The effect on the economy was catastrophic and caused a “pandemic” of foreclosures that effected tens of thousands home owners across the U.S. (Scaliger, 2013). The debt burden eventually became unsustainable and the U.S. crisis deepened as the long-term effect on bank loans would affect not only the housing market, but also the job market. What at first seemed to be an economic slump turned into a brutal crisis, and all eyes looked to the Government and Federal Reserve to help the economy.
Fiscal policy involves changes being made in government expenditure and or taxes with the aim of reaching certain economic objectives, such as stable prices, low unemployment and ultimately economic growth (Arnold, 2012). Arnold (2012) explains that fiscal policy may be expansionary or contractionary depending on the government budget. In mid-2007 the first signs of upset became visible in global financial markets (Stark, 2010). Stark (2010) explains that these signs were connected to a swiftly increasing crisis in the sub-prime mortgage market of the US, which had an negative affect on the prices of related structural financial products owned globally by banks and other financial institutions. Eventually, European banks were subjected to the unravelling of harmful financial instruments and to plummeting commodity prices and Western consumer demand for imports (Love & Mattern, 2010).
Euro zone nations were confronted with banking sector weakness and distress and large budget deficits resulting from past profligacy. Many Euro Zone nations borrowed heavily, mostly from external sources during the decade preceding the GFC. The borrowings were spurred by availability of easy credit. Blundell-Wignall and Slovik (2010) rightly observed that two inter-related crisis have confronted Europe: first a banking crisis, originating from losses due to the decline in asset prices such as housing and capital market losses; and second, a sovereign debt crisis due to poor fiscal management which is exacerbated by recession and transfers to help banks. The idea of Euro Zone with economic, commercial and financial interdependence carried seeds of vulnerability as economic volatility could quickly spread to other countries, resulting in a domino effect when confronted with the
Frederic Mishkin makes the point in the text, The Economics of Money Banking, and Financial Markets (2010) that “Banks and other financial institutions are what make financial markets work. Without them, financial markets would not be able to move funds from people who save to people who have productive investment opportunities.” (p.7). The movement of funds between savers and those with productive investment opportunities is the means of creating growth. When people lose confidence in the economy this activity freezes or weakens, consequently, asset prices decline, unemployment rises and companies default as was the case of Lehman Brothers in 2008. The freezing of the flow of money is a financial crisis.
The credit crisis is referred to as economic downturn by credit squeeze, provision of doubtful debt and bankruptcies among others. (IMF, 1998) Credit crisis is known as a credit crunch, it is an extension of recession. According to the Ocaya (2012), Credit crisis is a sudden shortage of loan and tightened the requirement of economy and society needs of getting loan from financial institutions. In such situation, lender started keeps the cash and stop lending money because they are worry about a large of debtor bankrupt and mortgage defaults. Lender had adjusted the interest rate of borrowing to unaffordable rate.
Furthermore, it became a worldwide phenomenon; “the way the debt was sold on to investors gave the crisis global significance. The US banking sector package sub-prime home loans into mortgage-backed securities known as CDOs (collateralised debt obligations). These were sold on to hedge funds and investment banks who decided they were a great way to generate high returns (and big bonuses for the oh-so-clever bankers that bought them). When borrowers started to default on their loans, the value of these investments plummeted resulting in huge losses for banks globally”, (timesonline.co.uk). As this was going on, consumers felt the effect of basic necessities prices increasing.
All of a sudden, people bought houses because there was an excessive amount of money in the economy and they thought the price of houses would only increase. (Amadeo, 2012). There was a financial frenzy as the growing desire for homes expanded. People held a lot of faith in the economy and began spending irrationally on houses that they couldn’t afford. This led to overvalued estate and unsustainable mortgage debt.
Between 2000 and 2007, there was a sharp increase in savings available for investment . This tempted banks and consumers to do high-risk lending and borrowing practices. When these bubbles burst, prices of commercial property dropped, causing banks in the U.S. and Europe to fall into debt. This created a domino effect on the economy. Consumers as well as governments were no longer able to borrow and spend.
The United States once had the largest economy in the entire world, and when there are problems with the US economy shock waves can be felt all over the world. The global economy is inter-connected on several levels due to the amount of international trade which occurs. If the United States does not find a way to manage its debt, or find a way to reduce the debt, it would increase the cost of finance for business because of the increase in interest rates. This could lead to high inflation. The stock market would also suffer badly as investors might feel that investing in the US market was too risky.