NEW YORK—Like Alan Greenspan before him, U.S. Federal Reserve Chairman Ben Bernanke's legacy will be defined by his ability to steer the U.S. economy away from a possible recession this year.
In the biggest threat to the global economy since the "dot-com" collapse, fallout from the U.S. subprime loan crisis and the resulting credit market crunch have spread far and wide.
Homeowners may see the value of their homes plummet. With mortgage-backed assets bleeding cash, banks and corporate earnings may suffer, driving down the stock market and investor value.
Unemployment will likely go up, as many jobs created during the past decade were to service the lending sector. As introductory rates on subprime loans expire and market rates kick in, borrowers will be further cash strapped. With already high gas prices, an overall decrease in U.S. consumer spending may trigger a global economic disaster – not to mention that financial institutions around the world invested untold sums into the asset-backed U.S. funds that have now collapsed.
Economists trace the beginnings of the subprime meltdown to U.S. monetary policy after the "dot-com" collapse and the 9-11 terrorist attacks. Record low interest rates and former President Bill Clinton's call to consumers "to get out and shop" created a real estate market boom unseen in decades.
The Perfect Storm
Between 1997 and 2006, average U.S. home prices increased by almost 125 percent, according to research from Economist. Easy credit, lax lending practices and an appreciating housing market encouraged many "subprime" borrowers—borrowers with low income or bad credit history—to obtain loans and adjustable-rate mortgage (ARM) loans with low "teaser rates."
Many mortgage firms overlooked the risk of lending to subprime borrowers. With rising real estate prices, even if a borrower defaulted, banks felt that a foreclosed house could still be sold at a profit. Greed, from speculators to mortgage companies to investment banks, along with an upbeat outlook on the U.S. housing market, had created the perfect storm.
"Many mortgage firms cut their loan underwriting standards, and we were losing business to more nimble mortgage companies which offered riskier loans. Loosening underwriting standards were becoming an industry norm. To generate volume, everyone was doing it," said a former subprime trader from Countrywide Financial Corp. who declined to be named. In 2006, 20 percent of all mortgages were considered subprime, according to a NPR report.
By late 2006, the housing market was showing signs of overheating. Interest rates also crept up, and many subprime borrowers couldn't make timely payments on their homes, many of which had been assessed at much higher than they were actually worth.
Consumers were hit hardest. From July to September 2007, almost 500,000 homes in the United States were subject to foreclosure, according to AP.
In her article titled "Your House is Not a Piggy Bank," Amy Hoak from MarketWatch discussed the dangers faced by retiring baby-boomers in the United States. Many consumers failed to save adequately for retirement, and depended on the value of their homes—home equity—as a retirement solution, she noted.
Far-reaching effects
The effects of the subprime collapse were broad. Mortgage companies and banks issued complex bonds and derivative securities backed by these subprime loans, which were sold far and wide. Hedge funds, investment banks, and institutional investors bought these assets, craving a share of the subprime market at the time.
Then, all came crashing down in 2007. As home prices fell, the value of these bonds dropped and losses piled up.
Effects on the U.S. financial sector have been staggering. Some mortgage lenders, such as New Century Financial Corp. and American Home Mortgage, are bankrupt. Merrill Lynch reported subprime losses of up to $9 billion., and Morgan Stanley announced more than $10 billion in losses. CNN calculates that losses at financial institutions related to subprime loans totaled more than $90 billion as of late December.
Overseas markets haven't been spared. Swiss bank UBS AG wrote down $10 billion in subprime-related assets, and British lender Northern Rock Plc asked the Bank of England for an emergency loan last September due to liquidity problems.
The crisis in the U.S. has also been a boon to foreign currencies, with the Euro increasing dramatically in value against the dollar, and even the Canadian loonie outpacing the dollar for the first time in over 30 years.
Many experts predict more pain ahead in the near future. Over the next 12 months, ARM loans issued in the past two years will reset to higher interest rates. With refinancing increasingly difficult, timely payments may become impossible for more homeowners.
President George Bush last month proposed a plan to allow a portion of subprime borrowers to keep their introductory interest rates for up to five years. Businesses are also scrambling to shore up their defenses, with mortgage lenders tightening their lending policies and banks evaluating their risk management strategies.
Some are already sounding the recession bell. With the world watching closely, fixing the U.S. subprime meltdown requires a joint effort from regulators, consumers, the banking sector, and the Federal Reserve. How the United States emerges from the subprime loan crisis may very well determine the future of the global economy in 2008 and beyond.
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