I have been trying to understand what the U.S. crisis was and why it affected the world so much, during 2008-09. I'm not a business student, so the complex words used to describe this phenomenon didn't help. However, after doing some searching over the internet, I finally got the hang of it.
It all boils down to one basic thing: greed. When people get greedy, they do all kinds of stuff without thinking about the ramifications of their actions.
The economic turmoil of the U.S started in 2008 when its "housing bubble" burst. What is this housing bubble? It refers to the times when a fat, fat lot of money was being invested in building new houses and putting them up for sale. Why? Because there was a mind boggling demand for houses, and they were selling like hot cakes. Such a demand had not been seen before.
The natural question is, what led to this sudden surge in demand? Actually, this demand was created artificially by wealthy investors who had a large pool of money and wanted to get bigger returns on their investments. So a new idea was developed, and it was called Mortgage Backed Security (MBS). The idea was that investors could invest their money in banks, and banks would lend this money as mortgage to the average American people who wanted to buy houses. The installments received from these borrowers would then be distributed back to the investors as returns. This idea gained popularity and a huge huge pile of money was invested in this. To obtain higher returns, banks attracted and enticed the common man to buy a house by offering easy availability of "adjustable" mortgage at very low interest rates. Adjustable mortgage meant that the interest rate would be very low for a certain period of time, and after that period expired, the rate would be increased at par to the current rates in market.
Due to extensive advertisements and lucrative offers, an extremely large number of people applied for mortgages. The demand was so high that there weren't enough houses to meet this demand. So this led to the housing boom, and a number of investors jumped into the housing industry, in the hope of getting very good returns. A large number of banks entered this sector too.
However, if the demand for a commodity increases, its price increases too. And hence, the prices of houses skyrocketed. They went up so high that even with the option of paying installments at very low interest rates, the average American could not afford it.
And thus, something happened which the housing industry experts had not expected. The demand for houses plunged. It went down so dramatically that in a matter of months, there were millions of newly built houses, and almost no takers for them. This meant there was a surplus supply of houses.
The large amount of money invested into building houses was now stuck! Since most of the banks had invested money in the housing sector, their money was now stuck and they had a shortage of funds. They had no option but to extract money from mortgage holders by increasing their interest rates.
These rates went so high that houseowners started failing to pay their installments. Those who failed to pay had to vacate their houses, and the bank put up these houses on sale. These houses added to the already overwhelmed surplus supply of houses. When there is a surplus supply for a commodity and very few takers, the price of that commodity decreases. The same happened here. The prices of houses started declining. And whoever had invested in this sector was losing money. To cover these losses, banks kept on increasing the interest rates on mortgages, which led to more and more people defaulting on their payments and vacating their houses, further lowering house prices.
One question arises that if house prices went down, why did the number of buyers not increase. The answer is that banks had no money to provide mortgage to new buyers. All the money they had was stuck in housing, and there were no more investments in the MBS scheme, as investors had already lost faith in it. So even if house prices were declining, the sale of houses could not climb up.
As house prices kept plummeting, interest rates sprialled out of control, and more and more people kept defaulting. This became a viscious cycle. There even came a time when the house's worth became less than the mortgage amount.
As investors started withdrawing their investments, the coffers of banks kept depleting. A time came when banks did not have any more money to pay its investors. This was the moment when they started to search for mergers, or request the government for bailouts. People were gripped with panic that they were about to lose their savings, as many companies came on the verge of bankruptcy.
Thankfully, the U.S government prevented a total economic breakdown by providing bailouts packages. But even then, a large number of companies shut down, or cut down their employee count. It took more than a year for things to take a turn for the better. But this event heavily impacted not only the U.S but also the rest of the world, because a large number of foreign funds had gone into the above schemes, and all of the companies involved incurred heavy losses . .
I hope this post helped you in some way to understand the U.S crisis and its impact on the world.. In the next blog I will try to explain about the European crisis that has now hit the world . .
