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Vicious Cycle that led to the Financial Crisis

Financial Crisis

Experts have citied a lot of reasons for the financial crisis. Due to increased demand for housing, and government policies encouraging subprime mortgaging, banks lowered minimum requirements and credit ratings of potential borrowers became less important. This led to mortgages being given to homeowners without a sound financial background. As interest rates began to rise, more and more homeowners were unable to meet payment obligations and the number of foreclosures rose.

All this was coming at a time when speculation was the order of the day. Investors purchase risky mortgage backed securities in a bid to gain on profits, even though such securities were leveraged (borrowed money used in the purchase). As homeowners became unable to pay, refinancing mortgages became more difficult as institutions became wary of defaults and U.S. home prices started experiencing a decline, making refinancing less profitable in the long run.

As a result of the decline in housing prices, 12 million U.S home owners had zero or negative equity in their homes and were actually servicing a mortgage based on a house which was now worth much less than it was when the mortgage was secured. Home owners in this situation were encouraged to walk out on the mortgage without risk of losing assets to the lender even though doing such will affect their credit rating. A walk out of homeowners in their larger numbers meant an increase in the number of houses in search of occupants. This also led to a further decline in housing prices.

Most investors in and out of the U.S who bought Mortgage-backed securities did so on monies borrowed from banks. As housing prices experienced a free fall and homeowners refused to meet up to their payment obligations, the value of MBS suffered. Investors were unable to service their loans and banks were unable to receive both new capital coming from investors buying Mortgage backed securities and interest from loans already issued. All this events on a magnified scale led to a lock down situation where banks didn’t have enough money to give out in form of loans, credit cards, and other facilities.

In a bid to remain profitable, banks increased interest rates on credit cards thus making it more difficult for consumers to avoid delinquency on their credit cards. Higher interest rates and stricter rules for issuing finance meant that consumers had less spending power, another phenomenom that had a ripple effect on every small to large scale business around the world.

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