The most popular explanation,according to Skidelsky in "Keynes", was the failure of banks to manage the new risks posed by financial innovation.Greenspan stated that the cause of the crises was underpricing of risk worldwide and the technical failure of risk management models. Particular attention was paid to the role of American subprime mortgage market as the originator of the so-called toxic assets which came to dominate bank balance sheets.A global inverted pyramid of securities also fell in value. Household and bank debt was built on a narrow range of underlying assets-American house prices.When they started to fall,the debt balloon started to deflate.Many of the loans had been made to sub-prime mortgage borrowers with poor prospects of repayment.Securities based on sub-prime debt entered the balance sheets all around the world.When house prices started to fall,securities also fell in value.Fearing insolvency,with their investments impaired by an unknown amount,the banks stopped lending to each other and to their customers.This caused the credit crunch.With collapsing confidence,stock markets plunged,banks began to fail and the economy started to slide.This brought about generalized conditions of slump throughout the world,which deepened throughout 2009.
Skidelsky states that American house prices rose 124% between 1997 and 2006,while the Standard & Poor's 500 index fell by 8%.Half of the US growth in 2005 was house-related.Home ownership increased from 64% to 69% between 1994 and 2005.The average price of an American home was three times the average wage for a long time in its history.By 2006, the ratio was 4.6% and rising.Two reasons were behind the boom.First,the Clinton administration encouraged government backed institutions like Fannie Mae to expand their lending activities.Second,private mortgage lenders,having exhausted the middle-class demand for mortgages,started to lend to people with no income,no job or no assets.Borrowers were enticed by teaser rates:very low,almost zero,introductory interest rates on adjustable-rate mortgage which went up sharply after a year or two.By 2006,more than a fifth of all new mortgages($600 million worth) were sub-prime.Mortgage equity withdrawals to buy consumer durables and second homes shot up from $20 billion in the early nineties to $700 billion by the mid-2000s.Monetary authorities had turned their populations into highly leveraged speculators in a fixed asset.In 2005-6,two blows hit he housing market:a rise in the cost of borrowing and a downturn in house prices.Between 2004 and 2006, the Fed,seeking to dampen inflation and return short -term interest rates to a more normal level,raised the federal fund rate from 1% to 5.25% and kept it their until 2007.US house prices fell 33% before flattening out.16% of sub-prime mortgages with adjustable rates had defaulted.These losses demolished the investment firms risk models based on mathematical formulas.The US credit-rating agency,Moody's,had also incorrectly awarded triple-A ratings to billions of dollars' worth of financial instruments because of a coding error in their model.
Many different entities were blamed for the Great Recession.Bankers,Credit-Rating Agencies,Hedge Funds,Central Bankers,Regulators and Governments were all blamed for the disaster.Skidelsky,interesting enough,blames the economics profession.The practices of bankers,regulators and governments can be traced back to the ideas of economists and philosophers.The crises is a not failures of character or competence,but a failure of ideas.Keynes stated that "the ideas of economists and political philosophers,both when they are right and when they are wrong,are more powerful than is commonly supposed.Indeed the world is ruled by little else".Skidelsky explores the present state of economics and I will bring you his thoughts in the next post.
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