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What caused the financial crisis?

01 Jul 2013

What caused the 2008 financial crisis? We all know it was linked to the US property bubble, but who caused that?

Governments in the US and Europe have conveniently blamed the banks for the crisis, but all the banks really did was create and trade on property related derivatives much as they trade on derivatives related to shares on the stock market.

Many politicians would have us believe that the banks are to blame. However, the underlying facts tell a different story.

Timeline

• Prior to 1996 only wealthier people were able to get sub-prime mortgages. All this changed in 1996, when the US housing department set a goal for Fannie Mae and Freddie Mac that at least 42 percent of the mortgages they purchase be issued to borrowers whose household income was below the median in their area.

• This target was then increased to 50 percent in 2000 and 52 percemt in 2005. This led to increased sub-prime lending, particularly to lower income groups.

• During 2001, US interest rates were decreased from 6.0 percent to less than 2.0 percent in order to fuel consumer spending. Rates were then kept at this low level until 2005.

The points above fuelled increased mortgage lending and speculation which caused US house prices to increase by 57 percent over the period between 2000 and 2006.

Rates were then put up to just over 5.0 percent in 2006 as the Fed suspected a property bubble was developing.

The US property market then began to contract in 2007, with house prices falling by 9.0 percent during the year.

A larger decline occurred a year later, in 2008, when US house prices fell by 18.6 percent.

This led to widespread panic in the market and a large number of homeowners defaulted, resulting in a run on a number of investment banks that had bought and sold large volumes of ‘toxic debt’ instruments related to mortgages including credit default swaps.

The US property market then began to contract in 2007, with house prices falling by 9.0 percent during the year.

The five largest US investment banks (with combined debts of US$4 trillion) either went bankrupt (Lehman Brothers), or were taken over by other companies (Bear Stearns and Merrill Lynch) or were bailed out by the US government (Goldman Sachs and Morgan Stanley) during 2008.

The true cause

Many people blame capitalism and greed of banks for the crisis but the truth may be precisely the opposite.

Socialism is the system whereby a society strives for equality. Equality such as allowing lower income groups to borrow at the same rates as higher income groups even though they are higher risk.

Governments in the US and Europe have conveniently blamed the banks for the crisis, but all the banks really did was create and trade on property related derivatives much as they trade on derivatives related to shares on the stock market.

The government was the one who decided to allow lower income groups to borrow at sub-prime rates and the government was the one who reduced interest rates in 2001. Yet somehow they have escaped any accountability.

Perhaps the real moral of the story is that governments should not be telling banks who to lend to and that capitalism and socialism don’t mix. - Andrew Amoils

About the Author
Andrew Amoils

Andrew Amoils

Andrew is the head of research at New World Wealth, a global wealth intelligence company based in Johannesburg. He can be contacted on andrew@nw-wealth.com.

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