Subprime: the 21th century financial crisis and ongoing
In year 2007, the world was shocked with financial crisis so called "Subprime" which led to downfall of the US economy. At that time, we still thought that this was happening in America only. Moreover, many people understand that it involve in Wall Street only. Dow Jones Index responds to Subprime crisis by stock market drop within a few days before it reach the highest point at 14,000. It was not until one year after when the crisis start to affect everyone outside the Wall Street from Subprime crisis to money crisis to credit crisis and to economic crisis.
At the end of 2008, US Consumer Price Index was collapse; many commodity pieces were going downward such as crude oil, zinc and rubber. Alan Greenspan, ex chairman of US central bank, admitted that he was misjudgment about private banks in America had enough capability and had decent defense mechanism to deal with the risk. Credit crisis was another name that called the subprime crisis, before it was change into financial crisis later on. Credit crisis in America create situation when there was too many actual money in the system. Back in year 2000 when stock market and American economy was in bad shape, only three things that President of America central bank, Alan Greenspan, did which were increase, decrease and steady the interest rate. Every time it is work and this time too. He managed with the economic recession by decrease short term interest rate to stay in the lowest as possible to boost investment and made people spent more money into the market (Petroff, n.d.). He dealt with recession during the year 2000 with his only tool, interest rate. Therefore, Fed started lowing interest rate season again. Fed had a policy to gradually reduce Fed Funds Rate, loan interest rate between financial institutions, for long time and longest in history from 5.5% to the lowest point at 1%. In result, the US financial system starts to climb again. Fed Funds rate during 2003-2004 was the lowest since 1971, if not include interest rate after the economic crisis(Wessel,2009) Private businesses all together showed their stunning total revenue in history, the US economic boom again. This credit and house price explosion led to a building boom and eventually to a surplus of unsold homes, which caused U.S. housing prices to peak and begin declining in mid-2006. The action was favor a lot, no body know that it would turn into nightmare later on.
Unlimited economic growth did not stay put but spread across worldwide, Market liquidity boost in various countries' central bank. Even in British and Japan both inject money in their banking system. Money growth at that time was called Cheap Money stage and easy to find. The following phase was money using without thinking much. The incident occurs everywhere in financial world, money flow easy and it left easy as well. Apart from norm people, large financial institutions also need money to invest too. Therefore, insurance companies, investment companies and mutual fund around the world were also use Cheap Money to buy assets from one nation with strongest economic stability, America(Sorkin, 2009). Of course the asset that was talking about was financial asset, the most wanted asset of all financial institutions was US government bond. Another large financial country that play big role in waning the US government bond was China, the world largest population and number one export country. Chinese economy grows rapidly with US dollar from exporting. Therefore, China returns the favor through economic means to the US, like other countries did, be the major investor in US government bond. The consequence was as predict, at that time world economy grow swiftly, inflation rate was low, total revenue of major companies were increase, it was never been like this in history. However, this economic growth makes people forget the word "risk" and "lost" out of their idea.
In the early 2001, a consequence that investors wanted to see from their investment in high risk assets like Junk Bond that had higher value than interest bond almost 10%. In year 2005, diversity that indicates risk premium was roughly at 4% and declining. This change showed that people in capital market not concern risk as something to be frightening. Everyone gave vital and value the risk extremely small, the demand for profitability ratios was also low. An important evidence to be considered was the difference between London Interbank Offering Rate (LIBOR) and US T-Bill. LIBOR was sharing interest rate from major banks in England, while T-Bill was an US government interest rate for private sector that brought government check, an interest rate without any risk. Therefore, the differences between these two rates indicate the level of risk premium at that time. During year 2002-2004, there was not much difference between two rates; however, in 2005 the difference start to rise and in 2008-2009 there was a big gap between T-Bill and LIBOR. Which mean investors who invest in risk assets want more return in exchange for risk, or in another word, the risk came with higher price. Evidence that show risk management was too low in US economy was loan credit policy that was too slack. If we look at risk point of view from loan institutions which gave loan by difference mortgage interest rate between good credit and low credit customers we can see that in 2007 the ratio was only 1.3% which reduce from 2001 at 2.8 %(Shiller, 2009). The last information that showed us clearly was Mortgage Delinquency Rate in Subprime assets which reduce in 2002 but start to go up again in 2005.
When the risk was consider as small, the result was people was not anxious the risk. The behavior of lenders changed dramatically. Lenders offered more and more loans to higher-risk borrowers. American people at that time showed that loan money was not something to be afraid of, except from the household that loan, in business sector still functions smoothly not aware of loan money that easy access. We can see clearly from Leveraged Buyout (LBO) business that growing rapidly in low interest rate period. One famous business at the time was Private Equity Fund which was sharing of wealthy individuals and ability in making loan of investment management. Interesting point in this investment was getting the money from sharing and from loan to invest in business that think it will grow or make profits back in future. When that business that was invested by the Private Equity Fund start to grow, next objection was to sell it to make more revenue to other funds, or individuals, or made it into Stock Market Company. Even though, the process was last long than a year, but the profit in return was enormous. Fed Funds Rate that was reducing was opposite to this form of business. Side effect from this low rate was something that Fed did not predict. Profit from large amount investment was an easily success and lure others to create more Private Equity Fund.
Small interest rate had high impact on American daily life, golden age of American immovable assets, money was lure out and the people who made that happen was financial institutions, lenders that gave loan to immovable business. Both had same the idea which was immovable assets was the most prosperous asset because of unavoidable insurance and the price continuingly grow. It helps convince American people there was no time like this to invest in immovable assets, have a house of their own since it was the time of the lowest interest rate has ever been and competition between lenders help the American people, who never own a house, to lent money to buy house. Those who already own a house could not resist temptation from financial institutions and the teaser rate. We would see house renovation; buy a second or third house. Everyone believe investment expertise that immovable asset investment was something that must be invested in and to have second or third house became normal. This believe occurred because everyone was told that investing in immovable assets will never loss. Everyone saw the same thing; the price of house will never fall. At that time, we would see commercial to invest money in housing but not to buy house as living asset but to make profit from it. This believes was not totally wrong because immovable assets life circle was five years. During the first year to forth year, price will gradually rise up and then the price start to fall in the fifth year. In this time, immovable assets life circle was 14 years; therefore it convinced people that price will not fall again from 1991 to 2005 (Sorkin, 2009). Having low interest rate and immovable assets boom was not happen only in America but it was happening around the world. Countries such as Britain, Japan and Australia that had over value in house were also facing the same problem as America did because economic structure was depend on immovable assets. Economic Bubble in immovable assets occurred around the world but what make this problem so important was it took place in America because immovable assets market in America was large and connected to other countries through investment in bond from financial institutions from Asia, Europe and Middle East especially Germany, the largest investor in American immovable assets.
Whoever borrowing in residential real estate would be proud and try to keep their house. If everyone who buys a house felt that way, there would be no "Foreclosure" sign all over America. However, having second or third house from investment was another story. Both investors and investment expertise agreed that whenever wanted real cash, they can sell houses which get profit from pricing and also use loan interest to reduce tax. Therefore, buying a house of American people was not for living subject matter but to hope for profit from investment or to be frank, it was buying land to make revenue. Have a loan of money to buy a house during low interest rate, land boom and immovable assets grow in America encourage banks and financial institutions that gave loan to people who buy a house. In the past, to manage to have a house in America, they must have strong job position, high salary and honor jobs. However, the situation change loan condition was not limited to middle class only but expands to working class. Banks were used to give loan to Prime Customer for house loan. However, when Bank giving too many credit until they could not find Prime Customers again. They turn their heads to people with low credit or called Subprime Loan. At first, loan was limited or had conditions attach to it. However, when there was competition between banks, make loan conditions change, not consider the risk of being Subprime Loan. Valuate immovable assets had been conspiracy by those who involve to get higher price as possible to benefit both side. Almost every bank transforms their loan system to meet their Subprime customers. Some banks gave loan through internet and approval within two days, therefore Subprime loan ongoing to grow rapidly. Giving loan to basically invisible people on internet was called Ninja Loan, therefore, the origin of this crisis came from two things; greed and money innovation.
American people action before the crisis showed us clearly that greed cause by underestimate the risk of buying house. Everyone appear to believe that price will not fall even the president of US central bank like Alan Greenspan once said immovable assets like house, the price will never fall. In fact, house price already drop about 20% and continuing to go down. In brief, in time of low interest rate economy tempt private sector to use loan money to over buy assets and made profit which lot of them never return. Business sector also over use loan money, in 1980 financial business in America had a loan at 21% of GDP while in 2007 at 116% of GDP. We could say that capital to make product and service in America came from loan. We saw that financial businesses in the system used their money the same way as in private sector did, which was speculation. Speculation from business sector which was the key of financial system started from two behaviors, which were asset loan to Retail Real Estate and Commercial Real Estate and the second was Leveraged Buyout (LBO). These two behaviors describe investment behavior of financial institutions even bank, social insurance fund or even Hedge Fund.
When situation in immovable business grow like skyrocket made bank or financial institution that involve in real estate look with enthusiastic, low interest rate was something investors like because they could find cheap money. When money was easy to find, the risk in investment was no longer be consider. Bank look the same as obligor who invest in land and estate that piece will never fall. They also believe immovable assets were the lowest risk assets because of high insurance price with a strong insurance. Normally, assets that bank and financial institution, both in America and other countries, own the most would be check and bond. Having low interest rate, almost like nothing, made bond no longer interested. Even loan money was easy to get and it was cheap money, and invested in bond made no profit back. At the same, investment that was considered to be stable and good profit was giving loan to immovable business. Therefore, it was no surprise that every financial institution in US turn over to real estate sector.
In, conclusion, George Santayana once said "Those who cannot remember the past are condemned to repeat it". History was something to remember and to learn from it, to prevent or minimize the damage, if there will be another economic crisis. Subprime crisis will be another event in history. While economic globe change, America once principal in financial and capital market for various countries, today it was challenge by the crisis, which was created by American people, how America will act and survive in major economic role. Crisis in 2008 spot many weaknesses in economic system today, capital development raise swiftly in the past decade was questioned. Should we stop financial growth to stop the crisis? The answer would be no, if we want to go back when each country had limited trade, capital did not flow freely, no saving money for elderly. In reality, the World did not function in that way anymore, capital move fast from nation to nation because confusion in market, risk was high and complicated to notice. Therefore, investors must know their financial market well, study the weakness, and plan their money wisely.
- Wessel, D., 2009. (Book) In Fed We Trust: Ben Bernanke's War on the Great Panic ISBN: 978-0-3074-5968-8 Retrieved 25 November, 2009
- Shiller, R., 2009(Book) The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It ISBN: 978-1-4008-2927-9 Retrieve 25 November, 2009
- Sorkin, A., 2009 (Book) Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System---and Themselves
- ISBN: 978-0-6700-2125-3 Retrieved 24 November, 2009
- Petroff, E., n.d. (Website) Who Is To Blame for the Subprime Crisis?
- Retrieved 27 November, 2009 from http://www.investopedia.com/articles/07/subprime-blame.asp?viewed=1