The Onset of Subprime Crisis

The current economic meltdown did not begin with the surface of subprime crisis in middle of 2007 but was in fact started with the building of progressive debt instruments immediately after the 9/11 attack of the World Trade Center in New York City in 2001.

The effect of ground zero in Manhattan caused tremendous social, security and economic fear and uncertainty in the US and beyond, triggering immediate tightening of security measures by world leaders to minimize the possibility of another devastating reoccurrence and to prevent panic from the financial sectors in anticipation of economic downturn.

Former US Federal Reserve chairman Allan Greenspan knew that the stock markets will be the first place to react to such magnitude of national disaster. The Federal Reserve's emergency 1/2 point cut and suggestions of more to come in attempt to stabilize markets, liquidity and earnings. Financial markets never opened on day of terrorist attack, and remained closed for the next four trading sessions. When stocks began trading again on September 17, the results were predictably gloomy. The Dow Jones industrial average plunged 684.71 points, its biggest one-day point loss in history.

As the dusts settled at ground zero and with the Fed continued to reduce interest rate to encourage lending, consumers were presented with choices of ingenious mortgage packages dished out by financial institutions to make homeownership possible to many Americans whom had never able to afford in the past to see the “American Dream” come true – owning a home. Second mortgage was also being pitched to the existing homeowners to refinance their properties to get lots of cash in hand and lesser monthly repayment; encouraging further spending by these second mortgagors on almost anything they could get their hands on – bigger lawn, swimming pool with Jacuzzi, kitchen with state of the art equipment, holidays to Europe, new MPV or TV set etc.

In order to maintain the hype in the property market and the upswing of economic conditions, bankers need to continue the supply of money to the home buyers and owners but the existing criteria for approval of loans to only consumers who possess favourable credit scores and FICO ratings would not achieve the desired economic objective. Therefore, ensuing in the adoption of a more liberated attitude on risk appetite by the financial institutions; credit approval criteria were relaxed to simply base on overall declared incomes without the need of verification and compliance to minimum credit rating requirement. However, the banks were at the liberty to impose adjustable interest rates for this higher risk group of borrowers and the contractual clause on the interest rate was either not fully divulged to the consumers or deeply hidden in the mortgage agreement that many had missed out.

The economy continued to expand exponentially requiring more liquidity to fund the housing markets; Collateralised Debt Obligations (CDO) was formed to create an investment instrument with securitisation of properties for public investments. Investment rating companies like Standard & Poor’s and Moody etc were hired by bankers and mortgage companies to rate the instruments. AAA or its equivalent was rated by various agencies based on the structure and credit worthiness components of the instruments despite the existence of blatant conflict of interest as these agencies were paid for the rating jobs.

The complexity of the debt instruments had found Allan Greenspan dumbfounded in understanding the rating and overall sensibility but ironically, the instruments were heavily and quickly subscribed by major investment houses, insurance companies, sovereign funds and the general public including Freddie Mac and Fannie Mae (government sponsored enterprises that purchased the debt instruments to increase market liquidity) starting from within the American soils and beyond, spreading across the Atlantics to Europe and subsequently to other parts of the world.

The basic economic theory of demand and supply finally set in where the property prices reached a ridiculous level in 2004, resulting in interest rate hike, heavy selling and the prices plunge in the following years. That marked the beginning of the property crisis in the US.

In late 2006 and beginning 2007, foreclosure started to take its toll - evicting homeowners out of their defaulted mortgaged homes, breaking many so-called American dreams and leaving them homeless. As the property values continued to nosedive and foreclosure escalated in mid 2007, the subprime crisis was finally exposed on a global scale sending the first financial warning to subscribers and owners of the CDOs around the world of an imminent economic tsunami. By then, banks and investment houses were already hoarding debt instruments that had yet been offloaded to the secondary markets, suffering tremendous losses that seriously affecting their balance sheets.

Panic began to build. Global major stock exchanges quickly reacted with merciless downward sliding of their indices, igniting financial crisis to all parts of the world. Bank refused to lend any more money until they have cleared their books of previous financing commitments. They were not only more reluctant to lend to each other; they were also more reluctant to lend to their ordinary customers, creating serious credit crunch and affecting the liquidity of many businesses especially the SMEs. Countries around the world, slowly and surely, entered into recession one after another.

The toxic assets in the bondholders’ balance sheets had created major liquidity and survivability problems, resulting in massive bailout initiatives and plans by the US government to combat the credit crunch of the banking system and the economic crisis leading to escalation of business closure and manpower downsizing. Other parts of the world except UK that are not having similar banking crisis as in the US are also continuing their efforts in reviving the economy and bringing it back to stability.

The world economy continues with no definitive answer and solution to the problem created by the current economic crisis, leaving overwhelming uncertainty in the marketplace and changing the way businesses are being run. However, if a chain of positive market reactions can persist and sustain arising from the global concerted efforts of rescue packages implemented by world leaders, we may see early than expected recovery of the economic disaster.