The subprime crisis

Exposé Politique & international Sciences politiques

Date de publication :

14/04/2008

Langue :

Anglais

Format :

.pdf

Nombre de pages :

10 pages

Niveau :

grand public

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5 fois

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Sommaire :

Sommaire

At the root of the subprime crisis: unsupervised innovation euphoria fuelled by excess liquidity
1. Due to Bernanke's ?saving glut? and loose monetary policy, liquidity was available for a housing and financial boom
2. That, combined with a lack of regulation, led to unsound financial decisions and, in fine, to the collapse of the subprime market and related assets
The current financial crisis has dealt a glancing blow at the financial sector and will have effects on the real economy
1. The financial sector is affected by both liquidity and solvency issues which will not be disposed with painlessly
2. There will be an impact on US and World real economy growth but its size will depend on United States' policy and the resilience of the emerging economies

Résumé :

Edward Gramlich in his presentation during the Jackson Hole yearly central bankers' symposium of August 31, 2007, said that: « productivity often improves in fits and starts; in other words, booms and busts play a prominent role. In the 19th century, the United States benefited from the canal boom, the railroad boom, the minerals boom, and a financial boom. The 20th century saw another financial boom, a stock market boom, a post-war boom, and a dotcom boom. The details differ, but each of these cases features initial discoveries or breakthroughs, widespread adoption, widespread investment, and then a collapse where prices cannot keep up and many investors lose a lot of money. When the dust clears, there is financial carnage, many investors learning to be more careful next time, but there are often the fruits of the boom still around to benefit productivity. » Indeed, the current financial crisis is another episode of excess investment due to unwarranted expectations of the results of an innovation. Investors thought the financial innovation there were using protected them from any risk. The slicing up of dubious loans and their repackaging minimises risk by spreading it. It does not eliminate this risk and that is what investors had forgotten. But that is not the whole story, and Gramlich acknowledges it when he says "the subprime market was the Wild West". It is the lack of adequate regulation, that allowed for predatory lending and "no-doc" loans, which, combined with the financial innovations of the last decade was the major source of the subprime crisis. The quantity of liquidity available in the market was an amplifying factor for, when liquidity is high, interest rates are low and the appetite for risk goes up. In a liquidity scarce market, there would never have been a market for residential mortgage backed securities (RMBS); therefore, there could not have been a subprime crisis. Once default rates reached higher levels, the portion of the financial system that was built around it collapsed. Markets dried up, confidence fled as the opacity of the whole system prevented informed decision-making. Highly leveraged conduits turned to the banks which had created them when they found it impossible to roll over their debt. Central bankers intervened forestall a liquidity crisis. After months of deteriorating financial conditions, the United States' economy seems to have plunged into recession. The fall of the housing market, artificially supported up to now by excessive lending, is a major way through which the financial crisis has had consequences on the real economy. The fear is that frightened and impoverished bankers will not be in a position to supply enough credit to the economy, thus fuelling a shortfall of growth. Having outlined the mechanisms of the current financial crisis, we will try to go further and understand step by step how the subprime crisis originated and its financial and real consequences. At each stage, we will propose policy action that could help mitigate the effects of this crisis and prevent a similar one from happening again.