Current International Financial Crisis



Current International Financial Crisis

Introduction

As you are all probably aware, the US is currently experiencing the biggest financial crisis after the Great Depression. And just like this past worldwide economic downturn, marked with massive bank failures and the stock market crash in 1929, today we witness the unforeseen bankruptcy of big, trusted banks and extreme market volatility.

Current International Financial Crisis: Policy measures that could be used to stabilise national economies

But how did we get into this situation? This article will try to explain the original causes of the current US financial crisis and its effect on the world economy. When examining the causes for the financial crisis most people start directly with the real estate market (the place where the crisis really began) focusing on the subprime mortgages and unscrupulous lenders and casting the blame on the unsustainable real estate bubble which began to collapse in 2006.

Whereas this is true, it is not the whole story. The whole real estate bubble originated mainly as a response to the huge demand of financial assets. And since not many places can actually provide such assets, naturally in such situations speculative bubbles come on the stage and become part of the supply response of financial assets to the demand of such assets.

This was the case with the real estate bubble too and that was one of the main factors leading to the current financial crisis: the excess capital globally pushed an enormous amount of money into the US mortgage market thanks to the securitization and the fact that almost 80% of the US mortgage market is securitized.

Basically, securitization is a wonderful financial vehicle. Mortgages are pooled together as securities and sold to investors. Of course, as securities, they can also be resold. Securitization creates diversification and liquidity. It also "smoothes out" the idiosyncratic risk of defaulting or going bankrupt.

Despite the existing lack of clarity and transparency (investors did not fully understand these vehicles and after all, it was hard to get information which houses are included in the pool) regular conforming mortgage backed securities were considered very low risk and were sold to investors not only in the US but also around the world.

And then, the idea of generating higher returns originated. Mortgages were now offered to high risk borrowers too, at the cost of significantly higher mortgage rates. Those subprime mortgages were put in big pools of assets ...