Strategies for dealing with the financial crisis

Causes of the Crises

Sub-prime Lending Homeowners: They want houses, and will get a mortgage (a loan for their house) to own one. Investors: They want a good investment, and usually they invest in the federal reserve, as treasury bills are a good investment. However, Alan Greenspan reduced the interest on treasury bills to only 1%. They then want a better investment than this. Banks: They were obtain cheap credit from the US federal Reserve and thus earned a lot of money Brokers: They sell mortgages to homeowners: Lenders: They provide the money for the mortgages. People and entities involved:

Sub-prime lending First, home-owners will buy a mortgage from a broker (who will earn a commission for each mortgage they secure). The lender of these mortgages will then sell the mortgages to the banks. The banks will invest a lot of money (up to millions) on buying mortgages, and they become responsible for collecting the payment on the mortgages The banks will then classify these mortgages as safe (lower interest rate, but they are likely to be paid back), okay (a medium interest rate, but they are still likely to be paid back), or risky (high interest rate, and least likely to be paid back) investments, and then sell them to investors based on the risk.

Sub-prime lending This worked well for a while – each time someone in the chain sold off the mortgage to someone else, they made money off of the deal. However, after a while, there were no new mortgages – most people who could own a home owned one, and so this meant the banks and investors could not make as much money. So, this lead to sub-prime lending.

Sub-prime Lending Sub-prime lending is when mortgages were given to people who weren't likely to pay them back (it was a high risk mortgage). However, brokers were so desperate to sell more and more mortgages for houses that they started lending to people who didn't qualify (ie there was no proof of income). Mortages sold in this fashion are sub-prime mortgages. These lenders then did not pay back their loans, and defaulted on their mortgages. However, banks assumed that even if the homeowners defaulted, there wouldn't be a problem, because that meant that they could keep the house, which they assumed would still increase in value (housing prices rose 124% from 1997 to 2006).

Sub-Prime Lending Many of the sub-prime mortgages were not paid back. This meant that the houses of the mortgages began going up for sale. However, there was a lot of houses for sale, and there was little demand – thus, house prices fell. Banks could no longer sell the mortgages to investors because they were poor investments – they were losing value. Then, brokers could no longer sell to banks, who did not want the mortgages either.

Sub-Prime Lending The banks, investors, and lenfers all had to borrow money to buy and finance the mortgages – so for all the mortgages they could not sell to the investors, they then could not pay back the loans. Thus, the banks, lenders and investors all went bankrupt (for example, Frannie Mae and Freddie Mac). Then, the investments that people made, because the investors went bankrupt, were also worthless, and so a lot of people lost money through this as well.

The Effects of the Economic Crisis

The Effect on LEDCs Although they were not hit as hard as Europe, the UK and the US, they did face slower rates of development – the economic growth in many LEDCs fell. This is because of globalisation – the world's economies are all connected, and so when the major economies of the US, UK and Europe fell, the economies of other countries were also affected.

The Effect on the USA The many major banks and financial institutions fell after the sub-prime loans. This resulted in high levels of unemployment. The shares that individuals and entities owned as well became worthless when the investment institutions went backrupt – so people lost money. The government of the United States bailed out various banks, to prevent further damage to the economy (for example, they bought the toxic assets, such as the sub- prime loans, to prevent bankruptcy).

The Effect on Europe It was not only American investors (such as hedge funds) that bought the sub-prime mortgages. European investors bought them as well, and so when the sub-prime mortgages were not paid back, Europe's economy was affected as well. Thus, they also experienced the job cuts and bankruptcy faced by the UK and US

The Effect on the UK As in Europe, investors in the UK bought the sub-prime mortgages as well. Furthermore, stocks fell once these institutions fell, thus resulting in many people losing savings and shares that they owned.

Solutions to the Economic Crisis

Public Spending Many governments, such as those of the UK and the USA have tried to encourage the public to spend money in retail again. This has been done through stimulus packages and tax cuts on retail goods. This allows people to contribute to the economy and allow businesses to make money, and thus allows businesses to pay back any bank loans they may have.

Job Creation The USA gave stimulus packages to different corporations, which would help ensure that they did not cut further jobs. This can be done by financial incentives for companies that hire people or stop the job cuts. This is necesarry because when people lose jobs, they do not spend as much, which can lead to the bankruptcy of more businesses.

Long term solutions Adding more restriction to banks. Breaking up financial institutions that are 'too big to fail' Nationalize banks which have gone insolvent (they don't have enough liquid assets). Financial institutions could be required to pay insurance permiums during economic booms – so that these can then be used to pay them during recessions. Agree for all countries to lower interest rates. Implement more screening and transperancy measures to prevent sub-prime loans.