The recession that engulfed the world economy in 2008 has taken the economic analysts by surprise. Questions have been raised about the effectiveness of economics as a predictive science. The recession was not the outcome of a business cycle fluctuation that macroeconomic theory has explained and solved in the past. It occurred entirely from a situation of market failure in the financial segment. It was the property bubble that inflated to such an extent that the whole world was affected when the bubble burst out in 2008. In this paper we are going to describe how this property bubble emerged and took such a proportion and how it affected the economy.
In around 2007 just after a recessionary period the interest rate in the US was reduced to quite low level to around 1 per cent. This was actually an outcome of monetary easing policy so that there is more credit flow in the economy. In times of recession the Fed buys bond in the open market so that there is more liquidity in the market. The yield on the treasury bonds are kept low so that people invest their money elsewhere and private investment increases that increases the output in the economy. With very low interest rates consumer spending increases and most of the spending is loan financed as loans come cheap. This low interest rate had resulted in the emergence of the property bubble in the US economy. The housing sector was in a boom with good amount of property trading.
This financial sector expansion led to a new type of lending known as the NINA (no income no assets). The bank advanced loans against mortgage of property without verifying the source of income of the borrower . With low interests and the new scheme of NINA loan taking became easier. There was huge amount of loans against mortgages. The banks sold these mortgages to financial institutions. The large financial institutions purchased these mortgages. Bundled them and securitized them. This created a new product known as the mortgage based securities. There was proliferation of CDOs during 2007-08. There was huge amount of investment in the MBS. Investments from India, China, and Saudi Arabia flowed into the US due to the low interests. Finding treasury bills with low yield the investments flowed into the MBS segment. Thus a global pool of money to the tune of $70 trillion flowed into the US financial sector .
In due course the Fed increased the rates. This made the securities more expensive. Debt servicing became difficult. The number of defaulters increased. The mortgage based loans also had clause of non-repayment. The inability of the debtor to repay the loan amount will allow the bank to take over the property and get back the loan amount by selling the property. Since there were a number of defaulters the property prices started falling. In spite of that the banks and other financial institutions were unable to sell the properties as there were no buyers for the properties. Thus the financial institutions were flowing with non-performing assets. This resulted in huge losses for the major financial institutions and led to the debacle of the financial system. The fall of the financial system led to fall in investment and production declined drastically. The investors were in utter dismay. There was a sense of insecurity among the people. This downfall of the financial system spread through the world as the huge global money pool was into the bankrupt US financial sector. Thus the whole world fell into recession.
Works Cited
Glass, Ira. The Giant Pool of Money. 2008. English. 29 March 2016.
