Comparison of the Sub-Prime Crisis in the US

Asian countries recorded such phenomenal growth and improved standards of living in the 1990s that they were collectively called the Tigers. For these countries, a golden era had arrived and the only way to go seemed forward. The dream of prosperity that the Tigers had in the 1990s would seem to have infected ordinary Americans who decided it was time to live the American dream. Central to this dream was the owning of a home. Suddenly, people who had never dreamed of mortgages or attracting the attention of a bank manager had all the finances needed to turn the dream of a home into a reality. Sub-prime loans, which came with less strenuous evaluation than prime bank loans, became easily available. Yet, like the Asian Tigers, the ordinary American who looked forward to a future of stability had a surprise in the waiting.

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The Asian Financial crisis started in Thailand in 1997 and almost immediately spread to other Asian countries (Jungjaturapit, 2008). In less than a year, the crisis had spilled over to the Philippines, Malaysia and Indonesia. Soon, Taiwan, Hong Kong and Korea were affected before the crisis developed a global outlook by spreading to Russia and Latin America (Jungjaturapit, 2008). The extent of the crisis in Asia is best understood by reference to the phenomenal changes that these countries had undergone before the crisis. Jungjaturapit (2008) shows the extent of prosperity that preceded the crisis with very impressive statistics for Thailand. In this country, annual per capita growth in GDP was 8.17% over a ten-year period. With much more money to spend, living standards in the country rose sharply and so did life expectancy and literacy. From a life expectancy of 58 in 1970, the figure had grown to 69 in 1995 while literacy rose from 79% in 1970 to 94% in 1995. Statistics from neighboring Asian countries were equally impressive. Pang (2000) notes the extent of growth in Asia by the expansion of the stock markets of the 5 ASEAN countries – Singapore, Malaysia, Indonesia, Brunei and Thailand. Between 1990 and 1995, these stock markets expanded to 120% of GDP from 40% (Pang, 2000). The region also attracted foreign investments like a magnet and Pang (2000) estimates that during this period the region was attracting 45% of the world’s private capital. The in-flows of foreign capital into Asia were $14.8 billion in 1993 and had increased to $86.3 billion in 1995 (Pang 2000). As a consequence of developments in Asia, Singapore gained new status – the city-state’s financial sector “was completely denationalized and its foreign market globalized” (Pang, 2000).

The miraculous growth in Asia was, however, soon followed by a crisis of unimaginable proportions. While the full impact of the crisis would only be felt in years to come, Jungjaturapit (2008) shows that declining economic growth was noticeable in Thailand as early as 1995. In that year, the GDP growth rate in Thailand fell from 8.61% to 5.24%. From then on, the Thai Economy was on a free fall and the growth rate would fall to negative7.57% in 1998. While many reasons are given for the Asian financial crisis, a paramount cause of the crisis, which also mirrors the situation in the US, was a rise in speculative buying. In Thailand, the government set up the Bangkok International Banking Facility (BIBF) in 1993 with the intention of providing finances for people interested in investing in the neighboring countries (Leightner, 2007). The government’s intention was, however, subverted by Thai nationals who took advantage of the loan facilities made available by the government to engage in speculative purchases. Huge demand developed for real estate. Through the BIBF, money from the US, Japan and Europe became easily available in Thailand. The locals who obtained loans from the BIBF were more interested in buying local property than invest in the neighboring countries as the government had intended. Rising demand for local property led to rising prices. Leightner (2008) observes that the speculators who purchased properties expected the prices of the properties to keep rising and their speculative buying led to more and more increases in prices. The speculative buying led to the purchase of properties at prices that were above the real value of the properties. When speculators realized that the prices they were paying for the properties were above the real value of the properties, they started disposing of the properties rather hurriedly. This panic selling led to a price collapse – the property bubble had burst (Leightner, 2007). People ended up with a property that they wanted to sell but which attracted no buyers.

The sub-prime crisis in the US is similar to the 1990s crisis in the Thai property market in a number of ways. Gordon (2008) traces the roots of the current sub-prime crisis to 1977. In that year, the Community Reinvestment Act (CRA) was passed and it required banks to lend “throughout the communities they served” (Gordon, 2008). While successive governments have been variously blamed for creating conditions that made the current crisis inescapable, central to all the discussions is that money was lent to people without proper evaluation. While banks have stringent lending conditions that involve a thorough evaluation of loan applicants, the entry into the lending market of sub-prime lenders made finances available to people who would not be in a position to repay loans. While it took more than twenty-five years from the establishment of the CRA for the property bubble to burst, Gordon (2008) sees recklessness in the lending industry that was fuelled mainly by greed on the part of the lenders and whose current consequences could not be avoided. Through the CRA, the law imposes what Gordon (2008) calls an affirmative duty on lending institutions to lend in the communities they serve, including poor neighborhoods. Fuelled by increasing greed on the part of lenders, a flurry of sub-prime lending took place in the 1990s and continued after 2000. The sub-prime lenders are blamed for approving loans in struggling communities without properly evaluating the applicants to verify their ability to pay. In fact, some critics feel that most of the sub-prime loans that were approved could not stand up to the slightest scrutiny. Defending the CRA from criticism for causing the current crisis, Gordon (2008) quotes Michael Barr of the University of Michigan who notes that the majority of the sub-prime loans were not made by banks that are under the regulation of the CRA but by mortgage companies that are beyond CRA regulation. Apart from mortgage companies, other sources of sub-prime loans were bank subsidiaries and affiliates. Brown (2008) sees the housing boom early in the decade as the root cause of the current sub-prime crisis. Some features of the loans show why they were a high-risk adventure. First, because of the low interest that was charged on the loans, prospective homeowners were able to obtain large loans. While most of the applicants could have been denied the loans if they went to a bank, these loans took a national and global character when they entered Wall Street. Sub-prime lenders securitized the loans that they issued and sold those securities to investors (Brown, 2008). While they were risky mortgages due to the poor credit rating of the borrowers, Wall Street sold these as risk-free securities. In addition to the poor credit rating of most sub-prime loan applicants, another feature of the loans that made them potentially dangerous is the fact that most of them were provided with an adjustable interest rate (Brown, 2008). This, coupled with the fact that most borrowers were falling behind in their repayments led to ever-increasing charges for homeowners. While trouble had been brewing for property owners who used sub-prime loans to acquire homes, matters became even more complicated during the summer of 2007 when scared investors, who were no longer sure that they would be able to obtain interest and principal payments on the securities issued started disposing of them (Brown, 2008). This led to massive reductions in the values of the securities. In addition, other forms of securities that were based on debt were similarly affected with the result that lenders became less and less willing to lend. This led to a credit crunch which the government feared was going to stall the economy. Some of the corrective measures that the government initiated included the lending of money to money lenders and brokerage firms and a reduction in interest rates (Brown, 2008).

As happened in Asia in the 1990s, the housing bubble in the US had burst. The consequences were many and varied just as were the victims. Naturally, the first victims were the homeowners. The values of the houses plummeted (“The causes and consequences”, 2007). Homeowners found themselves with properties whose value was lower than the purchase price. This meant that the homeowners could not enjoy refinancing for their mortgages. This has an additional consequence for homeowners – they still have to honor their mortgage payments, and since the interest rate is adjustable, this means that the amounts demanded from them are forever increasing. The eventuality is that the homeowner will be unable to service the mortgage and is forced to default. Of course, this leads to the loss of the home as the mortgage company will sell it to recover its money. While most would want to sell their houses and recoup some of the losses, it became even harder to sell even at throw-away prices. While the housing boom had been made possible by the availability of easy credit, the bursting of the bubble reversed the situation. It now became harder to obtain credit. For those keen on buying property, the process of obtaining a loan became more stringent. The panic among the lenders made them deny credit to people who in normal circumstances would easily qualify on the basis of their credit rating. In addition, interest rates shot up. During the housing boom years, most people were able to afford new homes because of the low amounts that were required as a down payments. With the bursting of the bubble, amounts required as down payment increased tremendously. In a nutshell, it became harder either to buy or sell a house.

The current sub-prime crisis, just as the Asian crisis of the 1990s has taken global dimensions. While it began with the bursting of the housing bubble in the US, the effects have been felt globally. Defaulting homeowners in the US were the trigger for the crisis in 2006 but the crisis was soon felt around the world (“History’s greatest financial fall”, 2008). The global statistics on the effects of the sub-prime crisis are mind-boggling. One of the first institutions with a global presence to feel the effects of the crisis was HSBC bank. In February 2007, the band terminated the services of its head of US mortgage lending when business losses reached $10.5 billion. By March of the same year, the biggest housebuilder in the US, DR Horton, had already issued warnings of massive losses as a result of the fallout in the sub-prime market. In the same month, one of the biggest sub-prime lenders in the US, New Century, had its shares suspended as fears were expressed that the company could be going bankrupt (“History’s greatest financial fall”, 2008). From then on, things deteriorated quite quickly. In April 2007, New Century Financial, a leading provider of sub-prime loans, layed off 3,299 workers and filed for bankruptcy. Another provider of sub-prime loans, UBS, terminated the operations of its sub-prime lending company, Dillion Read Capital Management. By June of the same year, $3.2 billion had been spent by Bear Stearns, an Investment Bank, to bail out two of its funds that were feeling the effect of the sub-prime crisis. As the effects of the crisis started to spread throughout the US, Federal Reserve Chairman Ben Bernanke warned that the cost of the sub-prime crisis could reach $100 billion. The effects were soon felt in the stock market. Beginning with the US, the Dow Jones slipped in July 2007 while similar effects were noticed in India’s Sensex. In August of 2007, one of the biggest providers of home loan capital, American Home Mortgage fired majority of the staff and filed for bankruptcy. In Europe, the French Bank, BNP Paribas announced the effects of the sub-prime crisis on its operations by saying that it was unable to correctly determine the values of the assets in three of its funds which had been exposed to the sub-prime lending markets. In August, liquidity problems were reported by one of Australia’s leading mortgage lenders, Rams. In the same month, sub-prime lenders in the UK began withdrawing mortgages. In Germany, one of the leading investors in the sub-prime market, Sachsen LB Landesbank, was on the verge of collapse in August 2007 and was only saved by being bought by Landesbank Baden-Wuerttemberg. Another German investor in the US sub-prime market, IKB, reported losses of $1 billion in September. In Asia, reports from the Bank of China indicated that losses from the effects of the sub-prime crisis in the US would reach $9 billion. As panic set in, Governments started to organize rescue packages for their institutions that were faced with collapse as a result of the crisis. In the UK, the government responded positively to a request by one of its largest banks, Northern Rock, for emergency financial support. Northern Rock was a major provider of mortgage funds which has since been taken over by the government. In Switzerland, the world’s biggest bank, UBS, reported losses of $3.4 billion resulting from the sub-prime crisis. The bank’s CEO, Huw Jenkins was forced to step down. Losses were also reported by banks in Japan. An indicator of the global extent of the sub-prime crisis is an agreement that was reached by the central banks of the world to act concertedly to boost confidence in a largely panicked world. To achieve this, the central banks agreed to inject $100 billion into the inter-bank credit markets. While president George W. Bush was admitting that the crunch was potentially devastating for the US and the World, the largest loss was reported by US giant, Bear Stearns. This company reported a loss of $1.9 billion in sub-prime related deals and had the CEO forced out. The casualties in the US and the rest of the world have been many and include the American Bank Lehman Brothers which collapsed in September 2008. Many more would make this list, leading among them being American International Group, AIG, which was given a lease of life by use of the Federal Reserve. AIG was in a group of companies that the US government decided to rescue from an imminent collapse by issuing a rescue package worth $700 billion (“History’s greatest financial fall”, 2008).

The roots of the crises in 1990s Asia and the sub-prime crisis are similar in the way they were caused by improper government practices. The real cause of the building boom that preceded the crisis in the US was the interest rates that remained very low for a a very long period. The government also encouraged the provision of credit to people with dubious credit credentials. Successive governments, both Democrat and Republican, have been accused of putting pressure on lenders to engage in what Brinsley and Veshkin (2007) call lax lending standards. Yet the government had only good intentions in encouraging the provision of credit to people who under normal circumstances would never qualify for loans and who would therefore be unable to ever own a home. The same good government intentions can be seen in the action of the Thai government in setting up the BIBF. The government had set up that facility to attract foreign investment which it hoped would be used to invest in neighboring countries. This was not to happen and the money ended up in the local property market leading to rising prices of property and eventually to a collapse. The crises are also similar in the manner in which they were fueled by dishonest dealing and greed (Tabb, 1998). In Thailand, for example, a good proportion of the money that the government lent was given to politicians who Leightner (2007) suggests viewed the money as bribes and not as loans that they were supposed to repay. This client-patron relationship in Asia is also noted as a major cause of the Asian crisis by Junjuturapit (2008). For this reason, when one of the leading lenders in Thailand, the Bangkok Bank of Commerce (BBC), started experiencing cash flow problems, it made moves to recover loan money that had been lent to politicians. Unable to return the money, the bank continued suffering and the government, fearing that the issue would become public and therefore lead to more problems for the bank, tried to cover-up those problems. However, the problems became public knowledge leading to the tarnishing of the bank’s reputation. The real effect of the fears about the stability of the financial institutions was a development of panic among the public. This led to a run on finance companies. Leightner (2007) notes that the finance companies that were especially affected were the ones that the public perceived to be weak. Had government exercised control over the interest rates, it would have carefully regulated the property market and could have stopped the speculation that eventually led to a collapse. Unrealistic expectations by the public were the result of greed. The public expected property prices to keep increasing and for this reason invested more and more heavily. In the US, providers of sub-prime mortgage finance have been accused of being led more by greed than the desire to help ordinary Americans acquire homes. Gordon (2007) accuses these lenders in engaging in “the most dangerous lending”. For example, some of the lending companies offered loans at twice the price of banks (Gordon, 2008). These companies pursued the profit motive greedily and recklessly leading to the current crisis. In Asia, Jungjuturapit (2008), quoting Paul Krugman, identifies two prime reasons for the crisis. These reasons are moral hazard and the overpricing of assets. Businessmen in Asia were able to overprice property because there was an abundance of money in their economies. This liquidity led to the development of a class of financial intermediaries who effectively made property artificially expensive. According to Krugman (Jungjuturapit 2008), investors, in making their investment decisions were led more by “best case scenarios instead of expected values”. In the US, the sub-prime loans were equally overpriced making them impossible to repay when the debtors got into problems.

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The crises also produced similar results as they both led to recession. In the case of the Asian countries, the local currencies suffered great erosion as a result of the crisis. The first to experience currency problems was Thailand. While trying to save the country from exposure, the Thai government, between 1996 and 1997 spent about $39 million in forward contracts which were meant to protect the local currency, the Baht, from speculators (Jungjuratip, 2008). The expense, however, soon became too expensive for the government and in July 1997 the government floated the Baht, thereby conceding that the economy was no longer manageable. Floating of the Baht led to immediate trouble for the local currency which fell to 30.18 to the US Dollar from 24.52 on the first day. While the Baht had previously traded at around 25 to the dollar, the worst happened to the Baht in 1998 when it fell to 56.10 to the dollar. One of the most immediate results of the fall in the Baht was a plummeting in prices in the Thai stock market. Faced by acute liquidity problems, the government turned to the IMF for assistance and was loaned $3.9 billion as stand by credit (Jungjuturapit, 2008). While the effects of the fall of the Baht were initially only felt by the people involved in trading using foreign currency, soon the effects spread to the local market and many businesses went bankrupt (Lincoln, 1998). As happened in the US and many other parts of the world that have been hit by the sub-prime crisis, businesses closed down leading to massive lay-offs. In addition, public expenditure reduced to a minimum further complicating matters. Interest rates soon increased tremendously thereby increasing the cost of credit. Jungjuturapit (2008) observes that interest rates in Thailand early in 1997 were 13.1% but had risen to 26% by the end of the year. As happened during the current crisis, high interest rates led to reduction in the level of investments as businesses were no longer assured of profitable returns on their investments. Some of the worst culprits of the new developments were businesses that had to repay loans. Unable to repay loans, these businesses soon closed down. Those that remained in business were fighting to stay afloat and some of the measures that were put in place in this survival game included reduction in the number of employees in addition to cuts in salaries and bonuses. The psychological effects could be seen in a generally panicked public who could not be sure what the future held. This uncertainty made people hold on to the money they had, effectively slowing down businesses throughout the economy. While Thailand was the first to suffer the effects of the crisis, the rest of the Asian countries soon experienced similar problems. The local currencies were especially hard hit as the world viewed the Asian economies as related and therefore expected problems in one country to be replicated in another. Whenever a government floated a local currency, the fall was immediate and potentially devastating. When the government of the Philippines floated the Peso in July 1997, it fell in value by 41.8%. Others Asian currencies did not fare any better. The Malaysian Ringgit was floated and fell by over 46.3%. The worst hit currency, however, was the Indonesian Rupiah which fell by over 84%. When the crisis spread to the rest of Asia, it was noticeable in the fallen values of the currencies: in Korea, the Won fell by over 54.6%. The real indicator of the extent of the crisis was the Hang Seng Index. This stock market index of Singapore fell by 23% in October 1997. For the city-state which had become the definition of success in the 1990s, the falling index was an indicator of massive negative change. The US dollar and other currencies in the industrialized west have been able to withstand the sub-prime crisis and maintained stability. Currency stability not withstanding, these economies have suffered the same fate as the Asian countries in going through a recession. The recession in Asia was particularly devastating and the kind of business closures that have been experienced in the west recently were everyday occurrences in Asia during the 1990s. Since the Asian countries relied most heavily on a very powerful export market, the falling currencies meant reduction in export earnings. Leightner (2008) notes the particularly indicative case of Thailand. When the Baht fell to 54 to the dollar in 1998, the value of Thai exports was reduced by a half. Moreover, this fall also meant that the prices that the country had to pay for its imports went up 100%. The effects of the recession in Thailand and the rest of the Asian countries was seen in the fall of the financial institutions. While 91 finance and securities companies were in existence in 1998, the number had fallen to 35 by mid-year (Leightner, 2008). Just as happened in the US and the rest of the West, Asian governments tried to mitigate the effects of the recession by organizing rescue packages for suffering businesses. The Thai government, therefore, obtained a loan from the IMF to help stabilize the economy. In addition, the Thai government did what the UK government has done – it took over some of the financial firms that had fallen in trouble. Even while the government was taking over ailing institutions and firing the managers who had been in charge, the measures proved to be too little too late. This was because by the time of the takeover, the institutions had become virtually worthless and in some situations, the shares of the companies had fallen to “1/1000th of their original value” (Leightner, 2008). The vicious cycle that has been experienced as a result of the sub-prime crisis had been observed in Asia during the 1990s. In Thailand especially, government take over of the ailing institutions came with a stern warning to the few institutions that survived. The government warned the managers of these institutions that they would personally be held liable for any loan defaulters (Leightner, 2008). This created fear in the managers of the financial institutions who henceforth exercised maximum care in providing loans. The results were more harmful than beneficial to the economy. To begin with, since they had discovered the stringent measures that banks had put in place, most debtors discovered that they would not be in a position to obtain new loans when they needed them. This made them less willing to honor the loans that they already had. The reason, explains Leightner (2008) was that a good credit ranking was no longer the prime consideration of lending banks. Just as people with excellent credit ranking in the US today are unable to obtain loans from banks, other factors were at play in Asia during the 1990s and further complicated matters for financial institutions. The debtors were able to arm-twist the lending institutions in a very simple way. Since those repaying loans were few, the debtors were able to negotiate with struggling banks to obtain repayment options that were more favorable.

Leightner (2008) observes that the crisis of the 1990s had very long-term implications for the banking industry in Asia. In four major areas, the relationship between financial institutions and borrowers changed dramatically. Not only did the number of lending institutions fall dramatically, some adversarial relationships emerged between the banks and the borrowers. Losing trust in one another, the financial institutions and the borrowers have continued to treat one another suspiciously. Leightner (2008) notes this effect with data from as recently as 2005. Thai banks are reported to hold more deposits than they actually need to make loans. In addition, these banks lack the motivation to provide loans because the interest rates they are allowed to charge is extremely low.

The Asian crisis and the sub-prime crisis had political consequences. In Asia, political heat was felt in Thailand where the prime minister, Chavalit, was forced to resign in November 1997 as a result of enormous public pressure (Leightner, 2008). His successor, Chuan Lepkai, guided the country more prudently and was able to put a check on official corruption which had been blamed as one of the leading causes of the crisis. In the west, the sub-prime crisis provided the Democrats with enough ammunition to fight the Republicans during the 2008 presidential elections. While many factors contributed to steer Obama to the White House, public frustration with the Republican president, George W. Bush certainly played a role. Public anger was expressed in some quarters when the government organized the bailout for huge corporations, such as AIG, when allegations were made that management in these corporations had actually contributed to the troubles in the companies by being generally reckless and wasteful.

The two crises have led to various lessons for the affected countries and the rest of the world. One of the lessons that came out is the fact that the world, because of globalization, is truly a village and the effects of a recession in one country will spread rapidly to related markets in the rest of the world. Just as the Asian crisis spread throughout the world, so has the sub-prime crisis spread globally. The crises also teach the importance of prudence and honesty in business transactions. Both crises had dishonest, greedy and generally unethical business managers at the head of important institutions.

In explaining the lessons that have been learned from the crises, it is important to take note of measures that were put in place by Asian countries to address their crisis. Thailand, on top of getting a new prime minister, effected a number of legal reforms which improved matters considerably. As part of legal reform, a new constitution was enacted which helped to reduce the influence of the politicians who had been instrumental in creating the crisis (Jungjuturapit, 2008). While the floating of Asian countries had led to near-ruin for the economies, the long-term benefits exceeded the short-term problems. Jungjuturapit (2008) notes that as a result of this action, prices of export goods were corrected and the currencies stabilized at positions that the previous pegging of currencies had made impossible. This lesson is equally important for the current crisis. Honestly allowing market forces to determine the prices of commodities without undue manipulation by greedy players will help avoid a repeat of the current crisis. Like currency pegging, manipulation of the sub-prime loans and the attendant false information that was peddled around eroded the credibility of the mortgage markets. This market rides on the back of public goodwill and as the world has learned the hard way, all that is required to create a crisis of global dimensions is the creation of panic in the markets. The importance of credible institutions is seen in the fact that once the public losses faith in the institution that is supposed to provide services, it becomes very hard to re-create that trust.

For the future, the current crisis and the Asian crisis would seem to suggest that people who are put in charge of services that have a direct effect on the greater public exercise utmost care and honesty. Since these virtues are not very easy to effect especially when the profit motive is overriding, managers of such institutions should be made personally liable for any losses that the public suffers as a result of their actions. While the actions of the Thai government to hold managers of financial institutions liable for their actions had some short-term harmful effects on the economy, the longer-run effects were increased efficiency and prudence in the management of public resources. When managers know that they could pay for their recklessness with a jail sentence, they will be more careful in the performance of their duties.

References

  1. Brinsley, J. & Veshkin, A. (2007). Paulson subprime is cheered by democrats, panned by right. Bloomberg press.
  2. Brown, J.(2008). Subprime crisis: A bouquet of opportunity masked a reek of risk. Knowledge @ Wharton. Web.
  3. Gordon, R. (2008). Did liberals cause the sub-prime crisis? The American prospect.
  4. History’s greatest financial fall: How it began”.(2008). Rediff news.  Web.
  5. Jungjuturapit, K. (2008). Has Thailand learned from the asian crisis of 1997?
  6. Leightner, J.E. (2007). Thailand’s financial crisis: Its causes, consequences and implications. Journal of economic issues 41(1), 61+
  7. Lincoln, E.J.(1998). End of the miracle: Exploring the Asian financial crisis. Brookings review 16(3), 4+
  8. Pang, E. (2000). The financial crisis of 1997-98 and the end of the asian development state. Contemporary southeast asia 22(3), 570
  9. Tabb, W.K. (1998). The east asian financial crisis. Monthly review 50(2), 24+
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