What are the reasons due to which we are in such a position? Let us analyze the problems which led our economy to this situation.

Main reason behind current US economic crisis is our over dependence on credit. Growth in US economy during the 1990s was mainly due to credit driven consumption by American people. Economic data shows that National Consumer Debt has more than doubled from $789 billion to $1.6 trillion between 1990 and 2001. Mortgage loans and credit card debts increased tremendously. Debt-Income ratio shot up from 67% during 1960s to 95.6% during 1990s.

The US economy received the first shock during the dotcom bubble burst and subsequent stock market crash in 2000 which led to a severe recession in 2001. Finance capital flew out from the IT stocks but soon found resort in the housing market. More and more investment in the housing market led to real estate boom and helped the US economy to recover.

Housing market boom in early 2K - Reason Now you may ask, why did the housing market suddenly become so lucrative to finance capital? There were 2 main reasons behind this: - i. Huge tax cuts during June 2001, which infused demand in the system. ii. Repeated Fed Rate cuts by Federal Reserve led to infusion of money in the system.

Real rate of interest became negative in USA between mid-2002 and early-2006. This fueled growth in credit market through creation of more and more credit at easier terms for the consumers. Debt of an average household in US increased significantly.

Mortgage lending and current financial and economic crisis

Fed rates, mortgages and housing market boom Repeated cuts in Fed rate increased liquidity of money in the economy. It in turn helped the mortgage lenders to lower mortgage rates to woo more customers. Easy terms and low mortgage rates fueled demand in housing market. Excess demand caused property price to move upwards. Real estate price increased at a breakneck speed.

Skyrocketing housing prices increased investor confidence to an all time high. The confidence was misplaced and highly inflated.

US mortgage market, mortgage-backed securities & financial market Mortgage lenders needed enough supply of funds so that they can lend more and consequently profit more. They repackaged these accumulated mortgage loans into securities. These securities were then sold off to renowned investment banks and hedge funds of Wall Street like Lehman Brothers, Morgan Stanley, Bear Stearns, Merill Lynch, Goldman Sachs and many more. Investment banks in turn pooled these securities and repackaged them into complex financial derivatives such as Collateralized Debt Obligations (CDOs). These securities are then rated by credit rating agencies. After being rated, these securities were sold off to security buyers in the secondary securities and derivative markets in the form of pension and mutual funds. Mortgage-backed-securities (MBS) market rose to a whooping $2 trillion by the year 2003.

Everything seemed so rosy. Financial market rose very fast along with the mortgage market boom. Consequently, the US economy had a stable increase.

Subprime mortgage lending
During 1990s US economy grew mainly due to real estate growth which was in turn credit driven. This made mortgage lenders reckless for more profit. They shifted their focus from prime lending market to a less ventured market of subprime mortgage. Thus, they started giving mortgage loans to such borrowers whose loan repayment ability was doubtful, known as Subprime borrowers.
Mortgage brokers allured these borrowers by arranging special and unusual financing arrangements: -

• Less documentation
• Self certification of income proof
• Comparatively low down-payment
• Sops of extension in periods for debt repayment
• Well devised interest rate structure which remains low for first few years but shoots up after the end of this period.

All these special arrangements were misleading and the consumers were allured to take these subprime mortgages which they could never afford to repay.

Subprime mortgages became highly popular among the masses especially among poor working class. Almost 14% of the total mortgages during mid-2007 were subprime ones. In addition, there are near-prime loans which accounted for another 8-10% of the mortgage market. These mortgage lenders were successful enough in generating demand for their products.

US subprime mortgage crisis and housing price bust
It was observed that people were unable to repay the subprime loans. Why? Default of subprime loans increased once the fixed rate period of these mortgages lapsed and the interest rates were reset to more than double of the initial rate. Consequences were natural and evident. Rate of default on these mortgages increased by leaps and bounds. Subsequently foreclosure and repossessions of houses linked with these subprime mortgages became rampant. In Cleveland, Deutsche Bank became the largest property owner of the state through these foreclosures and repossession of houses.

Suddenly this credit-driven demand in the housing market evaporated. Excess demand in the market was replaced by the excess supply of houses. Housing market found itself with only sellers and no buyers. This excess supply led to a decrease in housing prices. Property prices nose-dived from its all time high.
With fall in demand for houses, demand for mortgages also decreased. Consequently, value of mortgages fell. Once value of the mortgages fell complex financial tools such as mortgage-backed-securities, which were derived from mortgages, saw fall in its value too. Evidently prices of these financial securities tumbled down giving rise to a full blown financial crisis.

Consequences of US financial crisis

Collapse in the financial market affected some big corporation. Some of them are given below: -

• Mortgage lenders like Countrywide Finance were on the verge of bankruptcy.
• Fannie Mac and Freddie Mae were nationalized.
• Lehman Brothers, a renowned investment bank went bankrupt. It had made huge investments in subprime mortgage-backed securities and suffered unprecedented losses as a result of tumbling prices of the securities.
• Bearn Sterns had been taken over by JP Morgan Chase.
• Bank of America took over Merill Lynch.
• Morgan Stanley and Goldman Sachs transformed themselves to an ordinary bank, a bank for receiving and depositing money.
• Financial health of the largest insurance company, AIG, was also bleak. Thus, US government had to step in and bail it out by injecting $85 billion.

US financial crisis transformed to economic recession

Federal reserve chipped in with several monetary measures to pump in liquidity in the economy but to no avail. It has cut Fed rate to almost-zero level but still no sign of respite for the economy. Unemployment rate was around 6% level during August-September of 2008. Not only this, industrial production also declined by 2.8% during September 2008. Retail sales too declined by 1.2% from August 2008 to September 2008. Thus, what started as a financial crisis soon changed to a full blown economic recession.