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US caught cold

K Fatma
Media Hive News Network

Any crisis in the US has a direct bearing on other countries, particularly those who hold their foreign exchange reserves in dollars and invest them in US securities. Since global equity markets are closely interlinked through institutional investors, any crisis affecting these investors sees a contagion effect throughout the world. As we all know when the US sneezes, the world catches cold. But in the last two years the US has caught cold. Bankruptcy suits, expansion plans on-hold, pink slips, stocks crash, cost-cutting measures and plant shutdowns etc have occupied most of the spaces in newspapers, magazines and news channels during the period. Though some positive signals have now started coming out from the US, as well as other parts of the world, yet everyone is concerned what went wrong in the in the world’s largest economy? What was this financial crisis all about?

One of the reasons for this crisis is believed to be a housing loan crisis brought about by a competitive banking system as it resorted to sub-prime lending. Banks gave housing loans to many customers, who actually did not possess the requisite repayment ability. The banks were counting big on real estate boom and hence had overexposed their investments in the sector.

In the US, borrowers are rated either as “prime” - indicating that they have a good credit rating based on their track record - or as “sub-prime”, meaning their track record in repaying loans has been below par. Loans given to sub-prime borrowers, something banks would normally be reluctant to do, are categorised as sub-prime loans. Basically, it is the poor and the young who form the bulk of sub-prime borrowers.

Between 2002 and 2007, the banks gave loans to sub-prime borrowers on a two percentage point higher interest than on prime loans. It resulted in substantially higher EMIs for sub-prime borrowers than for prime borrowers, further raising the risk of default. Lenders also devised new instruments to reach out to more sub-prime borrowers. Being flush with funds they were willing to compromise on prudential norms. In one of the instruments they asked the borrowers to pay only the interest portion to begin with. The repayment of the principal portion was to start after two years. They did so because they believed that the real estate boom, which had more than doubled home prices in the country since 1997, would allow even people with unreliable credit backgrounds to repay on the loans they were taking to buy or build homes.

But the housing boom in the US started petering out in 2007. One major reason was that the boom had led to a huge increase in the supply of housing. Thus, house prices started going down. The prices had dropped almost 50% from their peak in 2006. This increased the default rate among sub-prime borrowers.

As the property prices went bust, so did their optimism on the prospect of those investments. This was exactly what happened to the world’s two largest financial institutions – Lehman Brothers and Merill Lynch – as they suffered huge losses. Lehman Brothers reported a loss of $3.9 billion in the quarter ending June 2008 while Merill Lynch posted a loss of $4.65 billion in the second quarter. With their stocks crash, Lehman filed for bankruptcy while Bank of America rescued Merill Lynch.

The National Bureau of Economic Research (NBER) had officially declared recession on December 1, 2008. According to NBER, the US entered a recession in December 2007. The bureau said that the country’s economic expansion lasted 73 months, from November 2001, before contracting.

To know more about recession, click here.