A short note on US Sub-Prime Lending Crisis 2007-8

 The “Great Recession” in 2008 showed the weaknesses in Western economic models. The crisis highlighted the differences in political and economic paths adopted by Western and Asian countries. It all started in late 1990s, when American real estate prices were soaring and banks provided mortgages to anyone without income guarantee until 2007 when the real estate prices fell and borrowers defaulted on their repayments. But before we analyze the crisis, it’s necessary to understand the western economic liberal policies which led to it.

After decades of government intervention, the US President Ronald Reagan and the UK PM Margret Thatcher started to “roll back the state” from national economies. They demanded a return to Adam Smith’s liberal policies which were encourage individual realization and reducing the social welfare spending. The renewed belief in ‘market’ and ‘invisible hand’ led them to believe that market itself would provide welfare for all.

Western Liberal Economy

Liberal economists often cited government intervention as unnecessary as it distorted the market and reduced individual capacities. As Milton Friedman said: People are not identical, they have different values, and different tastes and so on. When government intervenes in the market on the name of public goods, the result is coercive government. The market alone could provide a secure basis on which families and businesses can prosper.

Liberals also see democracy and economic development as inseparable. Some western liberals observed that Asian Financial Crisis 1998 was due to lack of genuine democracy. The European and American countries promote democracy and export their values to all over the world. For example, they often see individual freedom more important than community or family. But Asian countries such as China always preferred community over individual. As Samuel P Huntington says “the western views are misguided, false, arrogant and dangerous” as they think what is good for them is good for everyone. Thus, many observers cite neoliberal economic policies which caused the “Great Recession 2008”.

Subprime Lending

The US real estate market was booming. Banks were providing mortgages to anyone at lower interest rates to anyone. The borrowers bought homes on mortgages which they couldn’t have dreamt off. For instance, even bar dancers bought two or three homes and put it on rent. Banks were accumulating mountain of debts expecting that real estate prices wouldn’t go down.

But banks didn’t keep these mortgages with itself, they sold it to Wall Street investment firms such as Lehman Brothers or Bear Stearns. And these investment firms then bundled these mortgages with other loans and sold to investors all over the world. And then comes 2007.

Great Recession 2008

The real estate prices fell and default on loans increased manifold. As the prices of houses fell, the mortgages became expensive for borrowers.

For example, suppose you bought a home in Mumbai at a market price of Rs. 30 Lakh in 2006. You financed it through a home loan which was available without a collateral. But in 2008, the real estate prices fell. The market price of your home became Rs. 25 Lakh but you were still paying your interest at Rs. 30 Lakh. You found it illogical and stopped paying your installments. As the loan was without collateral, you didn’t worry about forceful freezing of your personal assets.

As people stopped paying their mortgages, the US banks cleaned their book by writing off $11.11 billion in home loans. Banks also stopped further lending fearing they wouldn’t be repaid.

But the American economy depends upon credit. Businesses borrows for purchase of goods, and people borrows to buy those products. In absence of credit facility, there was a liquidity crunch. In order to raise cash, American banks forced Wall Street investment firms to sell the subprime mortgages, bonds and stocks. As the sell-off started, the result was rapid fall in global stock prices. There were only sellers and no buyers at the stock exchange as everyone looked for liquidity.

Various banks filed for bankruptcy. Lehman Brother became the first to go bankrupt. Some banks were saved with government intervention and rapid-fire sale of distressed banks to other bigger banks. Bear Stearns was sold to JP Morgan Chase, Merrill Lynch to Bank of America, and the US biggest insurer, AIG was saved by Federal Reserve.

The US Crisis becomes Global Crisis

The crisis became global as it became apparent that foreign banks had large portfolios that included US subprime mortgages. It spread to Europe and Asia. Companies started to lay off their employees, countries started to default on their loans. According to an estimate, roughly 20 million people lost their jobs in 2007 to 2009. Sovereign debt crisis engulfed the European countries. Greece, Ireland, Italy and Spain were on the verge of collapsing.

The US companies laid off millions of employees which forced “reverse immigration”, immigrants returned to their homes. Spain, Japan and Russia brought their people home. As the immigrants started to return home, the income through remittances fell dramatically for many developing countries. For example, Philippines’s 10% of GNP was generated through people working abroad. Tajikistan’s 45% of GNP consisted of remittances. It caused political unrest and uprisings in many parts of the world.

The US since has recovered from the crisis and has performed much better than European Union and Japan. However, the Great Recession intensified about western values and “Casino Capitalism”. The continuous growth of Chinese economy has led many people to see the Chinese government managed capitalism as an alternative to Casino Capitalism.