Vol 6 (2009) - Issue 6

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A Brief Look at the Sub-Prime Crisis: Was it a Regular Business Cycle, the Result of Lax Supervision and/or a Regulatory Failure?

Introduction

'Not since the beginning of the First World War has our banking system been so close to collapse.'

The global economy has been in an interesting position over the last year. Many economies of all types, sizes and origins are in fear of, or actually in, recession. The terms ‘credit-crunch’ and ‘sub-prime’ are common parlance referred to on a daily basis by newspapers and common laity. This is a testament as to the force of sentiments held in common thought. Financial markets are built around risk and uncertainty. These markets are important because they handle much of the money in the economy. There is undeniably a need for regulation because of the ‘special economic role of money and the uncertainty associated with it.’ There is a great deal of contention over issues to do with how the current situation came about. The hunt has begun for those responsible. Critics and academics are pointing the finger of causal blame in all directions. Very few players in the financial sector have escaped criticism in some form.

The process of rationalising the various contributory factors is a complex task. To make any sense of the forces involved it is necessary to analyse and consider the build-up of the crisis from various perspectives. It soon becomes apparent that regulators were behind the trend in the markets. Regulatory approaches, monetary policies, macroeconomic factors and the general attitude towards debt combined to form the recipe for the current crisis. It is clear that it is the culmination of these various factors that has led to the current crisis and it is impossible to put the blame on one head. This paper shall attempt to describe the various contributory macroeconomic and regulatory factors, to assess their interactions and to highlight their importance.

The sub-prime mortgage

The term ‘sub-prime’ in this context refers to a class of debt issued by banks that is essentially more risky to those who were calculated to be less capable of affording repayments. In 2004 the interest rates in the US reached an all time low of 1%. This was a monetary policy designed to inject large amounts of money into the economy by increasing the supply. In simple economic terms, as the cost of borrowing decreases the quantity demanded will increase. With money being cheap and plentiful, banks could better afford to issue sub-prime products. Lenders began to issue more subprime mortgages with a high calculated risk, carrying higher than average chargeable interest rates. As the economy was doing very well and the value of property was consistently increasing there were very few defaults. If one were in difficulty it was possible to simply re-mortgage the property, taking advantage of the increased value of the property. The reduced frequency of defaults meant that the banks were making abnormal profits on sub-prime products, encouraging a higher level of interbank competition as they all wanted a piece of the action.

A state of predatory lending and intense competition began to take hold. Price competition resulted in lower interest charges on these mortgage products, reducing the cost of repayments and improving the attractiveness of the offer to would-be sub-prime home owners. Banks also competed in terms of product compilation. Mortgagor’s became more aggressive and creative, inventing new products, such as variable rate trackers and interest only. From the borrowers perspective, this was a very attractive situation and they took advantage of it.