Redes Electronicas

1 Subprime Mortgage Market and Current Financial Crisis
 

Philip Arestis 1 and Elias Karakitsos 2 Abstract This contribution demonstrates that the August 2007 financial crisis was the result of three forces: financial liberalization, financial innovation and easy monetary policy in a number of countries around the globe. The financial liberalization era allowed financial institutions toinitiate a new financial activity, which was based on the discretion of the banks to dispose of their loan portfolio in accordance with risk management. That financial innovation relied heavily on interlinked securities and derivatives, all related to asset backed-securities and subprime mortgages in particular. Subprime mortgages was a financial innovation designed to enable home ownership to riskyborrowers. It is, therefore, the contention of this contribution that the origins of the current financial crisis can be explained by these three interrelated features that have been going on since the 1970s. But the root of the current financial crisis is the creation and subsequent developments in the subprime mortgage market, the focus of this contribution. JEL Classification: E13, E32, E43Keywords: financial liberalization, financial innovation, monetary policy

CAMBRIDGE CENTRE FOR ECONOMIC AND PUBLIC POLICY CCEPP WP08-09 DEPARTMENT OF LAND ECONOMY UNIVERSITY OF CAMBRIDGE FEBRUARY 2009

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University Director of Research, Cambridge Centre for Economic and Public Policy, Department of Land Economy, University of Cambridge. 2 Associate Member, Cambridge Centre for Economic andPublic Policy, University of Cambridge and Director of Guildhall Asset Management, PCC, Ltd.

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Subprime Mortgage Market and Current Financial Crisis
 

1. Introduction The prevalent view is that the current credit crisis has its origin in the bust of the housing bubble. But what is missing from this view is that the finance of a bubble is only possible through a corresponding increase incredit – no credit, no bubble. Thus at the heart of the current woes lies the excessive liquidity that was put in place in the last ten years or so. 3 This liquidity financed in the first instance the internet bubble, but because there was no deleverage following the burst of this bubble the liquidity went on to finance other bubbles, including housing, private equity and commodities. Thus, thehousing bubble is a transformation of the previous internet bubble. The excessive liquidity in the 2000s was the result of three forces: financial liberalization, financial innovation and easy monetary policy in the US and Japan. In the US, Greenspan injected liquidity and cut interest rates following the AsianRussian crisis of 1997-98, which was only partially drained later on. Afraid of deflation inthe aftermath of the burst of the internet bubble, Greenspan cut interest rates from 6.5% to 1% and injected huge liquidity. More important, he was late and slow in draining that liquidity and reversing the rate cuts from the middle of 2004. Ben Bernanke has imitated Alan Greenspan and injected further liquidity following the ongoing credit crisis that erupted in the summer of 2007. This liquidityfinanced the last and most pronounced phase of the commodity bubble in the first half of 2008 that pushed e.g. the price of oil to $147 per barrel. The commodity bubble was the last one in the current cycle, as it affected CPI-inflation. Whereas central banks are loath in hiking rates to curb asset price inflation, a surge in CPI-inflation falls squarely into their realm. The surge in commodityprices forced some central banks, like the ECB, to tighten monetary policy, whereas it delayed others, like the Fed and the Bank of England, from the urgently needed rate cuts, thus contributing to the downturn in the autumn of 2008. The acceleration of the economic downturn in the third quarter of

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Liquidity for the purposes of this paper is to be understood not merely as reflecting...