A Background on the Global Financial Crisis: the Case of Sub-prime Lending

In looking at the roots of the current global financial crisis, there is a common consensus as to its cause: sub-prime lending. Simulating the economy generally requires more activity such as the case of more active consumer spending. It is a common dream among many people to own their homes instead of spending money on rent which in the end the space they live in, at the end of the day, is not theirs.

However, realistically, not all people can afford to buy their own houses, which is why in the terms of lending, mortgages have long functioned on prime lending or lending money to those who can actually afford to pay off their obligations. What is interesting is that in the United States, there is actually the aspect of risk that financial institutions can buy and then sell, and this has been made possible because of the structure of the financial system in the country.

This is to say that behind sub-prime lending, there are actually the components that enabled the creation of this form of making credit more available to people without the usual requirements needed in any prime lending situation. The long history behind sub-prime lending demonstrates how these financial institutions have been greedy while using the American dream of owning a home as the real reason behind these mechanisms. The complexity of the financially institutions’ mechanisms leading to this form of lending can be initially pointed at two main components: the people who want to buy houses and the investors.

With American investors wanting to put their money where they can get generous returns, the Federal Reserve would seem like an attractive vehicle through Treasury Bills although the time came when interest rates were lowered at 1%; with a low interest, investors did not find the Federal Reserve as an attractive venue of investment, but American banks and other financial companies that can be collectively known as Wall Street found the lower interest as a tool for them to make loans and inject more products and services available to the people and the investors.

In addition to the loans from the Federal Reserve, Wall Street also found another source of loans, and these were through means of surpluses from other countries such as China and even wealthy countries in the Middle East like Saudi Arabia. With loans willingly pouring into Wall Street, money for the people, especially the potential home owners, would be made readily available. Initially this worked well with the prime lending arrangements. Common system goes potential home owners approach brokers for houses, and brokers sell them the houses and even assist them in securing the loan; the loan is then secured to lending companies.

Lending companies, in turn, would provide the mortgage to the new homeowners, but lending companies have also found this practice of selling off these mortgages to investment bankers who collate all these mortgages and create a collaterised debt obligation or CDOs which would identify and categorise mortgages from safe to risky. Apparently, as safer rated-mortgages (AAA and BBB) can be easily sold, the American financial structure enabled the risky mortgages (those in which homeowners would default their mortgages) to be sold to other banks, which, in turn, can be also further sold.

Since that the aspect of risk can be covered by securitization, the idea came that if risk would be present in prime lending situations and that risk can be covered through securitization, it would be possible to further simulate the market by selling houses to those who may not easily afford these homes which is why this arrangement is referred to as sub-prime lending. The sub-prime lending framework would enable any potential homeowner to own a house in which, in some cases, no financial documents were required nor proof that the loan can be paid off by the prospective owner.

In Australia, a similar system can be found in lending frameworks known as “low doc” or low documentation, or “no doc” or no documentation. Hence, this set-up alone is risky, but because of securitization, such risks can be sold off to other banks. In a way, the financial system in the United States would enable a circulation of risk within the system, and given the country’s position in the greater economic landscape, these financial institutions from banks to investment and lending firms would even ask for loans from foreign institutions.

Initially this would work for all the components involved: people get to own their homes, the broker makes a profit, the lending company can sell off the mortgages to investment bankers at significant fees, the investment bankers earn a lot of money from selling off CDOs, and investors actually profit from good credit obligations. With such arrangement, the financial system in the United States can be regarded to be active and dynamic, and for years, people were happy with the credit system in the country because this would enable them to spend more.

In addition, with consumer spending increasing in the United States brought by more lenient credit and loan arrangements, the economy can be regarded to somehow benefit with these activities. Apparently, the problem is that these financial institutions lent more money to those who cannot actually afford it; initially, what would make this problem more crucial is that since lending would actually bring more profit to many agencies from the brokers to the lending agents, this would create a new form of redlining.

This is to say that with this set-up, more predatory lending agents would emerge. Moreover, credit schemes would prove to be confusing or even deceiving to potential loaners such as in cases where people can easily access money without the typical prime lending requirements but the catch is that their interests would actually make them pay more. Interestingly, such set-ups have been found to be common among the poor in which in the end, they see themselves signing for loans and in financial obligations that will drown them in debt for most of their lives.

On the side of the financial institutions, they also find themselves in trouble if they find that the homeowners are no longer making payments. The CDO an investment banker operates is suddenly filled with cases of foreclosed homes, and instead of money coming in, the investment banker finds himself or herself selling homes in order to acquire money. Since that there are more foreclosed homes in the market, and that the demand for houses would also decline, the tendency is that property values would also go down.

As a result, those who own homes and find that the value of the house they are paying have drastically dropped, what happens is they sell and look for a house they are willing to pay a lower mortgage for. Hence, the market is suddenly filled with houses of little value, the investment bankers and the financial institutions, from the banks to the lending firms to private investors, are no longer profiting. Worse, they still have outstanding debts not only with the Federal Reserve but also with foreign lenders.

In such scenario alone it can be gathered that although it seems that foreign lenders would be the only ones affected, it is actually surprising to know that the banks themselves are simulated both by private and public money, such as nations having stakes in international banks. The problem is since this happened in American financial institutions and these are heavily invested in, the chain reaction of these events would eventually create an impact even to the farthest reaches of the world.

This is to say that the financial institutions themselves, from Freddie and Fanny to the Lehman Brothers have a string of stakeholders involving international financial institutions. Hence, even the root of the problem is in the financial system, the impact has actually reached the economic levels which is why many companies have been slashing off workers, cutting down on expenses, and in some cases, many companies have closed. The profits that came with buying and managing risk would apparently result to an actualised set of risks which would cause sever impact all over the world.