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Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
1
1.0 Abstracts
This paper will discuss about the subprime mortgage crisis toward Caribbean Island and it has
related on US mortgage crisis in the same year. Actually, subprime mortgage crisis begun 2007
until 2008 and stated at US, these financial turmoil start with the cause and look through the
consequences on effect toward on Caribbean Island. In terms on the causes these turmoil are
likely boom and bust in housing market, housing bubble, high-risk mortgage loans and lending
or borrowing practices, collateralization and securitization and last capital adequacy
requirement. The causes will leads to the consequences on affect to Caribbean Island. There
are several effect namely trades activities, tourism sectors, Caribbean financial institution and
also foreign direct investment (FDI), last in others remittances. This paper will end with several
recommendations that useful to recover the crisis and ensure that to improve the imbalance in
terms trades activities, tourism sectors, financial institution and as well as FDI, and last on
remittances expenses.
2.0 Introduction
The financial press is full of stories about the collapse of the subprime mortgage market, what
caused this collapse and who should bear the blame. Sub-prime mortgages are generally for
borrowers with a low credit score. They often have higher interest rates, prepayment penalties,
balloon payments, and run a greater risk of foreclosure. Many times, subprime mortgages are
adjustable rate mortgages. These start out with a low rate for the first year or two and then
adjust every 6 months or more to a much higher rate. Lending to homeowners and buyers
without good credit has become a very bad business and a very big problem for the U.S.
economy as a whole.
Sub-prime mortgages include mortgages with very low or no down payments and second
mortgages that serve as the down payments for first mortgages to eliminate the need for a
cash down payment and a monthly premium for private mortgage insurance. Although sub-
prime and other risky mortgages were relatively rare before the mid-1990s, their use increased
dramatically during the subsequent decade.
An undeniable fact in the current subprime loan crisis is that, as more individual
homeowners default on their home mortgages, an increasing number of investments, which
rely on payments from those mortgages, will fail. The magnitude of investment losses from this
Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
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crisis is currently incalculable as this multifaceted travesty unfolds. Certainly, investors will lose
billions. Losses from subprime mortgages will surface in a number of investments portfolios
including: pension plans, governmental agencies, insurance companies, non-profit charitable
organizations and mutual funds. Many fixed income investments which rely heavily on
mortgages to pay their investment obligations are at significant risk of investment losses.
In our discussion and findings part, we will elaborate more about the causes of
subprime mortgage crisis and its effects on Caribbean.
2.1 Scope of study
The financial turmoil start at US when the failure of Bear, Streams & Co (NYSE;BSC) caused
by global process of de-leveraging. This leads to subprime mortgage crisis at 2008, the crisis
make the private market face 1 trillion amounts contained subprime mortgage. Other than that,
the subprime mortgage also occurs by agency debt, as well as paper issued by government
sponsored entities. In addition, some of financial institution was collapsed for instance; Citibank
reported US$9.83 billion net loss during this period, caused by a US$18.1 billion write down in
subprime losses. Here is having several issues that likely the roof of problem to enhance the
subprime mortgage crisis. When demand is more than supply (everyone wants to buy house),
the property values went up like crazy. Until one day, when it becomes much more expensive
to borrow, less people could afford to buy a house. As there were not as many buyers, the real
estate market begins to cool down and house prices begin to fall.
This paper also indentifies the consequences of the 2008 financial crisis on the
countries whereas; to identify and investigate the cause of the crisis and also identify the
channel through it will exert its impact on developing countries. In this research we focus that
the subprime mortgage effect towards Caribbean. First, under the literature review we put the
proof about cause the crisis and effect towards Caribbean. Second it’s discussed about the
cause such as homeownership, This organism such as companies, banks, associate and
government agencies enhance the availability of “affordable to finance housing” or refinancing
housing by using the creative financial techniques. Also discuss about roof problem is rapid
growth of over-the-counter (OTC) derivatives and securities by all the financial institutions,
under this situation also supported by encouragement of SEC and federal bank regulator. This
Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
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is leading to a breakdown in safety and soundness at banks and securities. Other than that,
problem is an ill-advised change in reporting standard for public companies means it’s related
on embrace by the SEC and Financial Accounting Standard Board (FASB) of the fair value
accounting. Further study on this paper which the study underlines several cause and effect.
On the cause it more generally because the turmoil financial crisis is stated on US, so we
identify namely boom and bust in housing market, housing bubble, high-risk mortgage loans
and lending or borrowing practices, collateralization and securitization and last capital
adequacy requirement. Other than that, this study underlines several effects toward Caribbean
Island likely trades activities, tourism sectors, Caribbean financial institution and also foreign
direct investment (FDI), last in others remittances.
Furthermore, the scope of this study is referring US mortgage crisis and also its
consequences effect toward on Caribbean Island. This is necessary background for
understanding the effect and requires responses. Also discuss the option the impact of the
crisis, arguing that crisis makes it imperatives to accelerate financial development international
financial system. Based on the surface this study it discuss the subprime mortgage crisis on
how Caribbean economies may be effect. And the main consequences are, first, Caribbean
economies will nonetheless feel the impact from the meltdown in the US financial market.
Second, the effect of the subprime housing crisis and the third is remittances from relatives in
the United States play an important role in the economies of Latin America and the Caribbean.
Lastly is undoubtedly after the housing bubble burst. In concludes is refer to limitation during
research and some of recommendation of this mortgage subprime crisis and the effect towards
Caribbean.
2.2 Objective of study
The main objective of study is;
a) To identify the causes of subprime mortgage crisis
b) To determine the effects of subprime mortgage crisis towards Caribbean
Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
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3.0 Literature review
According to Raina Antonopoulos, what began as a subprime mortgage debacle in the United
States has by now become the worst global financial crisis since the Great Depression. As of
February 2009, all advanced countries were in recession, with a job crisis intensifying across
the board. IMF and DESA world economic growth projections now stand in negative territory.
ILO estimates warn that the ranks of the unemployed will expand by as much as 52 million
within the year, up from a previous figure of 20 million. In the meantime, international financial
and trade flows are contracted at rates not seen in the past fifty years. Statistics thus far also
show that, for developing countries, not only export demand and tourism, but also worker’s
remittances, have been declining at alarming rates, all of which imply reversals of financial
flows. (Antonopoulos, 2009)
Trough the journal of The Financial Crisis of 2008 and the Developing Countries, said
that follow the burst of the ‘dotcom’ bubble in 2000 and the 2001 terror attacks on the United
States, the US and most other advanced economies embarked on a period of sustained
expansionary economic policies to ward off recession. The Federal Reserve, for instance,
lowered its discount rate no less than 27 times between 2001 and 2003 (Lin 2008). Low
interest rates, facilitated by the huge trade surpluses which China and other countries used to
purchase US Treasury Bonds, stimulated rapid growth in credit. Accompanying rises in house
prices further fuelled credit growth, especially through mortgage lending. In the US, subprime
market mortgage lending, to households without the essential means to repay loans, took on
huge proportions; according to Lin (2008) about US$1.3 trillion was lent in subprime mortgages.
(Naude, 2009)
Other than that the deepening crisis in the subprime mortgage market has affected
investor confidence in multiple segments of the credit market, with problems for commercial
mortgages unrelated to subprime, corporate credit markets,9 leverage buy-out loans (LBOs),10
auction-rate securities, and parts of consumer credit, such as credit cards, student and car
loans. In January 2008, the cost of insuring against default by European speculative bonds had
risen by almost one-and-a-half percentage point over the previous month, from 340 bps to 490
bps11, while the U.S. high-yield bond spread has reached 700 bps over Treasuries, from 600
bps at the start of the year. (Michel G. Crouhy, 2007)
Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
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From 2000 to 2006, the USA observed a rapid rise in housing prices. In some areas
housing prices doubled, which increased far beyond the rate of fundamental economic growth.
The housing bubble was mainly the result of oversupply of US dollars, leading to “over flows of
dollars” in the housing market through the provision of low interest rates by the US Federal
Reserve. The Federal Reserve cut interest rates by a total of 550 basis points between 2001
and 2004. The low return on the stock markets and treasury bonds further pushed money to
flow into the housing market to boost the housing bubble. Much of this money was lent to the
households who otherwise would not be qualified for mortgage loans.(UNHABITAT, 2011)
According to Economic Commission for Latin America and the Caribbean (2008), the
epicenter of this economic weakening are subprime mortgages which are highly risky
mortgages issued to borrowers who could not qualify for ordinary or prime mortgages due to
low incomes or bad credit history. This is due to the United States economy is currently
confronted with many challenges catalyzed by the property bubble bust. The collapse of real
estate prices has resulted in unprecedented losses and bankruptcies of hedge funds, mortgage
lenders and banks and has led to unnerving uncertainty on Wall Street and global financial
markets. The drastic increase in housing inventory, followed by sizeable reduction in house
prices, gave rise to negative equity for both subprime and prime homeowners. Being the main
asset of most households, the collapse of the price of houses has had a significant negative
wealth effect, which will undoubtedly reduce consumption significantly. Caribbean economies
would be affected through different channels which are trade, tourism, remittances, finance and
FDI.
Naude (2009) argued that there are many and various channels for the impact to affect
countries differently, depending on the extent to which they are vulnerable to particular
channels. A slowdown in economic performance in most developing countries during 2009 will
be affected in the form of lower growth, higher unemployment and poverty, and changes in
inequality. Two factors in particular have encouraged asset managers to throw caution to the
wind which is the growing global economy and their pay incentives. Risk-management tools
have been inadequate in properly assessing risk during the upswing in the global economy.
Rating agencies in particular seem to have been awarding high ratings much easier under
favorable growth conditions.
Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
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The examination stated that the difficulties are attributable to familiar mistakes rather
than to new features of the financial system. There has been concern that the failure of some
hedge funds could lead to more systemic problems. The problems are not simply the
consequences of using a new technology. Rather, the problems arise from a failure to
recognize: (i) the incentives affecting different participants, (ii) how those incentives changed
with the dynamics of market growth, and (iii) the need for tougher forms of risk control as the
quality of the borrower pool changes. Johnson & Neave (2007). Besides that, Study shown that
the cross-country causes of the financial crisis are hard to pin down with standard econometric
techniques (Multiple Indicator Multiple Cause (MIMIC) model). However, the author provides an
early warning that model-based early warning systems are unlikely to predict future crises
accurately. Rose & Spiegel (2009).
Some study support that the global nature of the crisis imposes to the governments the
adoption of a systemic approach and it is also necessary a change of perspective, that is a
change of culture by decision makers who, inspired by the categories of ethics and morality,
should find the balance among entrepreneurial and personal interest and collective interest.
Iannuzzi & Berardi (2012). Interventions and fiscal stimulus packages must be commensurable
with the seriousness of the problem and it is the responsibility of the state and of the global
community to put in place policies and strategies that will lift all boats, and lift them more evenly.
The worst scenario ahead does not rest with the instability deficit spending brings; rather, it lays
in the deadly combination of the despair poverty engenders Antonopoulos (2009).
According to Rhoda Reddock and Juliana S. Foster (2009) on Caribbean, they have
stated that women are at the center of the fallout from the current crisis, which itself combines
interlocking crises: a global economic recession, the devastating effects of climate change, and
a deepening food and energy crisis. All of this is compounding the increasing poverty and
inequality in different parts of the world, as well as the impacts of the HIV and AIDS pandemic.
At the same time, traditional power relations among international players are shifting, the so-
called ‘middle income countries’ with the BRICs (Brazil, Russia, India and China) assuming
greater power.
The current situation, a result of aggressive free-market capitalism pursued in the past
decades, calls into sharp question dominant and even many of the so-called alternative such
as models for development of the developing countries that have struggled with crises in the
Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
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70’s, 80’s, 90’s and beginning of 2000’s. This crisis, however, reached global proportions when
it impacted hegemonic economies and their role in global arenas and put in evidence the
interconnectedness of the diverse realities of countries in this globalized world.
Yet in Godfrey Smith (2008) statement said that the financial trauma affecting the US
economy would have already plunged the Caribbean into an economic coma. It is unlikely that
this will happen. But the outward ripples of the financial crisis in the US will cause an economic
downturn in the Caribbean. In the Theoretically way, the third parties picking up these
securitized instruments would do so only after reputable credit rating agencies had given an
investment grade rating to the transaction. But often, the credit rating agencies are paid by the
company that is selling the debt to investors, giving rise to questions of conflict of interest. But
International investors were on the receiving end of downgraded Belize investments just like
the international investors who picked up the US subprime mortgages have suffered losses in
the hundreds of billions of dollars, because Belize and much of the Caribbean do not have a
stock market, there probably were not many investment banks or investors to speak off that
would have picked up US mortgage backed securities.
Stock exchanges exist only in Jamaica, Barbados and Trinidad and Tobago. Direct
financial losses from the US housing crisis may therefore not be that substantial in the
Caribbean. As these bring the Caribbean consequences in economies will nonetheless feel the
impact from the meltdown in the US financial market. The effect of the financial crisis will most
immediately be felt in the tourism sector which is the primary foreign exchange earner for most
of the Caribbean. The general financial climate in the US may also cause people to be more
conservative and postpone vacations in order to save.
Some studies said that investors are adequately protected if all relevant aspects of the
securities being marketed are fully and fairly disclosed. The reasoning is that full disclosure
provides investors with sufficient opportunity to evaluate the merits of an investment and fend
for them. It is a basic tenet of federal securities regulation that investors’ ability to make their
own evaluations of available investments obviates any need that some observers may perceive
for the more costly and time-consuming governmental merit analysis of the securities being
offered. There are two levels of reasoning that explain the insufficiency of disclosure in the
subprime crisis. First is whether institutional investors will hire securitization experts as needed
to decipher complex deals. But is rejected by the evidence and theory explain. The second
Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
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reason is goes to agency costs stemming from a conflict between the interests of individual
employees and the institutions for which they work. Steve Schwarcz (2008).
From the 19th Annual Conference of the Caribbean Actuarial Association (2009), the
Caribbean economies’ fastest growth period since the 1960s has been abruptly interrupted by
the worldwide economic crisis that began with the meltdown in the US financial system. The
impact on these countries is being felt through a slump in exports that started in late 2008, and
falling tourist arrivals in the first nine months of 2009 that led to contracting GDP in nearly all
countries, rising unemployment, and declining government revenues. Investment activity has
also plummeted, and is reflected in sharp reductions in foreign direct investment flows and a
downturn in the construction sector. While there have been no financial panics as in earlier
external shocks, some countries such as Antigua and Barbuda, Dominica, Guyana and
Jamaica, are grappling with large current account and fiscal deficits, as well as difficulty in
accessing private external financing. These countries have limited room to implement policies
that could moderate the production and employment effects of the crisis. Hence, several of
them have either settled or, as in the case of Jamaica, are negotiating borrowing arrangements
with the IMF.
The overall it must be concluded that the variables we investigate as potential
determinants of the financial crisis of 2008 deliver only disappointing results. While many seem
like they should be empirically relevant determinants, in practice they are simply not closely
linked to crisis severity. These results indicate that creating an empirically viable early warning
system will be challenging; such a system must conquer all the problems we faced, while also
being able to predict the timing of future crises out of sample. (Spiegel, 2009)
According to journal of ECLAC a financial crisis in the United States would also affect
FDI as banks would be more reluctant to grant loans to multinational corporations and the
resulting increased uncertainty would make them less willing to invest. In this context, this
would also negatively affect the Caribbean countries. Notwithstanding, it is worth noting that
this effect could be offset in countries with abundant oil and mining reserves. This is true
because of the unprecedented high prices these commodities have recorded recently, which
make investment in these sectors highly profitable. Table 8 presents FDI as a percentage of
GDP in 2002-2006.(ECLAC, 2008)
Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
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4.0 Discussion and Finding
In this paper, we support the use of the emerging literature in new institutional theory on the
interplay of organizations and institutions to understand the current financial crisis. On this part,
we elaborate several causes of subprime mortgage crisis and its effects towards Caribbean.
4.1 The causes of subprime mortgage crisis
Housing bubble (Boom and bust in the housing market)
The sub-prime problem could not have happened without the housing bubble, it is
happened in the early 1998-2000 and it is could not have happened without the Federal
Reserve's accommodative interest rate policy. The proximate cause cannot provide a full
explanation about what exactly happened of the sub-prime mortgage crisis. The US housing
market leads to the problem such as the housing bubble. According to Vukovis (2010) the
housing bubble was due by the lowered of interest rates and increased incentives for mortgage
and lending and home ownership. This kind problem is affect and started to inflate as financial
innovation through the securitization of mortgage and their repackaging into new type of
securities made this possible. The bubble grew large when as more and more securities were
being underwrite.
Actually, the housing bubbles are happen cause of the US house prices rose
dramatically from 1998 until late 2005; John Marshall (2009),and the rise of pricing house is
reflected large increases in demand for housing and happened despite a rise of supply for
housing. The situation on housing bubble also leads the lower of interest rates, which these
encouraged people to refinancing they house; mean simply related on borrowing money in the
lower inters rates, as we can prove it has strong evidence where in many parts of the US, it had
become a lot easier, and cheaper to receive a subprime mortgage.
Major cause subprime mortgage crisis that affect Caribbean Island which in terms of
trade whether weakening of household consumption and business investment would directly
initiate a curtailment of demand in the United States for foreign goods and services.
Occasionally, the direct impact of a reduced demand will be felt most severely by countries that
have a large share of their export to the United States. These make sense to Caribbean which
decline the number of trade on it island. In other hand, according the research by United Nation,
Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
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the cause of mortgage crisis also has related on fuel price crisis since 1971-2007, in 2007 also
has happen the price shock, these matters effected Caribbean tread.
Declines in home values
Researchers, policymakers, and the general public have noticed that a large number of
mortgage defaults and foreclosures followed the decline in house prices. This observation
resulted in a general belief that the crisis occurred because of declining home values. The
decline in home values only revealed the problems with subprime mortgages; it did not cause
the defaults. Research shows that the quality of newly originated mortgages was worsening
every year between 2001 and 2007; the crisis was brewing for many years before house prices
even started slowing down. But because the housing boom allowed homeowners to refinance
even the worst mortgages, we did not see this negative trend in loan quality for years preceding
the crisis.
Homeowner speculation
The availability of subprime mortgages in the United States did not facilitate increased
homeownership. Between 2000 and 2006, approximately one million borrowers took subprime
mortgages to finance the purchase of their first home. These subprime loans did contribute to
an increased level of homeownership in the country at the time of mortgage origination.
Unfortunately, many homebuyers with subprime loans defaulted within a couple of years of
origination. The number of such defaults outweighs the number of first-time homebuyers with
subprime mortgages.
Given that there were more defaults among all (not just first-time) homebuyers with
subprime loans than there were first-time homebuyers with subprime loans, it is impossible to
conclude that subprime mortgages promoted homeownership.
High-risk mortgage loans and lending/borrowing practices
Banks offered easy access to money before the mortgage crisis emerged. Borrowers got into
high risk mortgages such as option-ARMs, and they qualified for mortgages with little or no
Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
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documentation. Even people with bad credit could qualify as subprime borrowers. Fraud on the
part of homebuyers and mortgage brokers helped make the mortgage crisis more serious.
Mortgage applications were not checked for accuracy as well as they should have been. As
long as the party never ended, everything was fine.
Securitization practices
Cause of subprime mortgage also because of securitization accelerated in the mid-1990s. The
total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, and
the amount is $7.3 trillion. The securitized share of subprime mortgages such as for those who
passed to third-party investors via MBS whereas increased from 54% in 2001, to 75% in 2006.
American homeowners, consumers, and corporations owed around $25 trillion during 2008.
Then after that American banks reserved about $8 trillion of that total directly as
traditional mortgage loans. Bondholders and other traditional lenders provided another $7
trillion. The remaining $10 trillion came from the securitization markets. The securitization
markets started to close down in the spring of 2007 and nearly shut-down in the fall of 2008.
During this time more than a third of the private credit markets thus became unavailable as a
source of funds.
Early of February 2009, Ben Bernanke stated that securitization markets remained
effectively shut, with the exception of conforming mortgages, which could be sold to Fannie
Mae and Freddie Mac. The relationship between securitization and the subprime crisis relates
to a fundamental fault like underwriters, rating agencies and investors modelled the correlation
of risks among loans in securitization pools.
Correlation modeling is the technique which is to develop by David X Li. this technique
determining how the default risk of one loan in a pool is statistically related to the default risk for
other loans and it is based on a �Gaussian copula� technique developed by statistician David
X. Li.
This technique also, widely adopted as a means of evaluating the risk associated with
securitization transactions, used what turned out to be an overly simplistic approach to
correlation. Unfortunately, the flaws in this technique did not become clear to market
participants until after many hundreds of billions of dollars of ABS and CDOs backed by
Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
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subprime loans had been rated and sold. Because of that situation the investors has stopped
from buying subprime backed securities, which halted the ability of mortgage originators to
extend subprime loans. So this effected to the crisis were already beginning to emerge.
Policy
i) Government policies
Although the reasons are many and distant in the years, the root cause of the global financial
crisis of 2007-2008 is the growth of the bubble of real estate loans, as an effect of too much
liquidity placed on the market by strongly expansive monetary policy of the Fed of Greenspan.
Between 2001 and 2004, in order to strengthen the labor market and the economic system, it
lowered the interest rate to 1 percent. This, together with the propensity for speculation and
over-indebtedness expressed by American peoples and fostered by generous ratings and
widely optimistic evaluations of risk, led to a dilation of mortgage loans.
A high percentage of these loans were subprime and Alt-A mortgages, namely loans of low
quality. The new Basle II capital requirements made it attractive for banks to invest in super
senior tranches. Money markets funds are required only to invest in AAA rated assets. Other
financial institutions are regulated only to invest in investment grade assets. These investors
provided a receptive market for the AAA rated asset backed bonds.
ii) Policies of Central banks
Central banks manage monetary policy and may target the rate of inflation. They have some
authority over commercial banks and possibly other financial institutions. They are also less
concerned with avoiding asset price bubbles, such as the housing bubble and dot-com bubble.
Because of this acting of Central banks, Central Banks have generally chosen to react
after such bubbles break open so as to minimize collateral damage to the economy, rather than
trying to prevent or stop the bubble itself. This is because central banks need to identify an
asset bubble and determining the proper monetary policy to deflate it are matters of debate
Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
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among economists. Some market observers have been concerned that Federal Reserve
actions could give rise to moral hazard.
A Government Accountability Office critic have been said that the Federal Reserve
Bank of New York�s rescue of Long-Term Capital Management in 1998 would encourage
large financial institutions to believe that the Federal Reserve would intervene on their behalf if
risky loans went sour or unpleasant because they were “too big to fail.”
A contributing factor to the rise in house prices was the Federal Reserve�s making to
lowering of interest rates early in the decade. From 2000 to 2003, the Federal Reserve lowered
the federal funds rate target from 6.5% to 1.0%. This was done to soften the effects of the
collapse of the dot-com bubble and of the September 2001 terrorist attacks, and to combat the
perceived risk of deflation. The Fed then raised the Fed funds rate significantly between July
2004 and July 2006. On this situation it is encourage and contributed to an increase in one
year and five year ARM rates and making ARM interest rate resets more expensive for
homeowners. So because of this, it is may have also contributed to the deflating of the
housing bubble, as asset prices generally move inversely to interest rates and it became more
riskier to speculate in housing.
Inaccurate credit ratings
Subprime mortgages went to all kinds of borrowers, not only to those with impaired credit. A
loan can be labeled subprime not only because of the characteristics of the borrower it was
originated for, but also because of the type of lender that originated it, features of the mortgage
product itself, or how it was securitized.
Specifically, if a loan was given to a borrower with a low credit score or a history of
delinquency or bankruptcy, lenders would most likely label it subprime. But mortgages could
also be labeled subprime if they were originated by a lender specializing in high-cost loans
although not all high-cost loans are subprime. Also, unusual types of mortgages generally not
available in the prime market, such as “2/28 hybrids,” which switch to an adjustable interest
rate after only two years of a fixed rate, would be labeled subprime even if they were given to
borrowers with credit scores that were sufficiently high to qualify for prime mortgage loans.
The process of securitizing a loan could also affect its subprime designation. Many
subprime mortgages were securitized and sold on the secondary market. Securitizes rank
Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
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ordered pools of mortgages from the most to the least risky at the time of securitization, basing
the ranking on a combination of several risk factors, such as credit score, loan-to-value and
debt-to-income ratios, etc. The most risky pools would become a part of a subprime security.
All the loans in that security would be labeled subprime, regardless of the borrowers’ credit
scores.
The myth that subprime loans went only to those with bad credit arises from overlooking
the complexity of the subprime mortgage market and the fact that subprime mortgages are
defined in a number of ways not just by the credit quality of borrowers. One of the myth’s by
products is that examples of borrowers with good credit and subprime loans have been seen as
evidence of foul play, generating accusations that such borrowers must have been steered
unfairly and sometimes fraudulently into the subprime market.
Oversupply of US Dollars
i) distort real economy
To maintain the expansionary fiscal and monetary policies, United States has supplied more
money to financial market and made US dollars “overflow” in financial institutions. This result
causes the oversupply of dollar that led to the increased commodity prices, inflation and
reduced the purchasing power parity of US dollar. Usually the magnitude of currency problem
can be reflected in the rise of gold price, for instance the gold price increased from USD 288
per ounce in 1999 to more than USD 905 in 2008 and early June 2011 the gold currency had
rise to USD 1,530. The oversupply of US dollars led to the depreciation of US dollar, household
needed to spend more money for same amount of services and consumption in non-housing
items. So as the consequences in less money available for them to pay housing mortgage and
increased their chance of defaults in their residential mortgages.
ii) making financial institutions lowering lending criteria
The oversupply of US dollars largely increased the liquidity of US dollars and the US financial
institutions are full of US dollars, these causes the financial institutions have increased
pressure to lend out the oversupplied money so financial institutions should expand their client
base to absorb the money. The subprime mortgage a loan is the innovated new products of
Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean
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lowered their lending criteria where they lent money to clients who are not qualified for loans on
conventional criteria. Unfortunately, these instruments had contributed to the subprime
mortgage crisis because people could not repay their loans.
Deregulation opens door for subprime lending
These factors also contributed to the boost of subprime lending, in 1980 the United States
passed the Depository Institutions Deregulation and Monetary Control Act ( DIDMCA) which
helped the Savings and Loan (S&L) industry to offer checkable deposits and allowed the
financial institutions to charge interest rated they choose. While in 1982, the deregulation
continued with the way of alternative mortgage transaction parity which preempted state laws
that restricted banks from making any mortgage except conventional fixed rate amortizing
mortgage.
It is also allowed the use of variable interest and balloon payments and allowed
lenders to make loans with term unclear the total cost of loans which led to new mortgage
instruments and cause many borrowers failed to understand and could not afford. These laws
had opened the door for development of subprime market but it not became a viable large
scale lending alternative until the passage of Tax Reform Act of 1986 (TRA). The TRA removed
the tax deduction of interest on consumer loans but encourage the homeownership initiatives
throughout the increasing the home mortgage interest deduction as well as the addition of low
income housing tax credit to boost homeownership for low income households. By 1995, the
US federal government executes a major reform of Community Reinvestment Act (CRA) and
issued the National Homeownership strategy which led the financial institutions to lower the
mortgage lending standards. By the way, these increased the riskier and unsustainable lending
practices through lowering mortgage underwriting standards and shifting from ensuring the
equitable lending procedures without careful considering of the borrower’s ability to repay the
mortgage loans.
Reckless lending of financial institutions
The reckless lending by financial institutions is factor contributing the subprime mortgage crisis,
the financial institutions give subprime loans to individuals who do not qualify for prime credit
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and basically not suitable for credit from traditional sources. Mortgage lending allows the
unsuitable borrowers to get credit which is they often unable to offer a down payment, unable
to pay debts and do not have source of income. In the case of those who have income, their
credit liability is disproportional to that income. The financial institutions went down markets to
reach income and the lenders would promise loans with less paperwork but quick approval and
no down payments. Financial institutions would attract the subprime borrowers with easy to
gets loan and short term interest rates for the beginning years but they subsequently had to
reset to higher rates for the majority of the loan period. The lack of diligence had resulted
different types of subprime loans, some loans required little documentation of borrower’s ability
to meet repayments while other loans needed no proof of income or credit history. In addition
the mortgages were also sold by brokers and intermediaries without assessing the buyers’
affordable capacity.
Globalization, technology and the trade deficit
During a year of 2005, Ben Bernanke addressed the implications of the United States’ high and
rising current account deficit, resulting from U.S. investment exceeding its savings, or imports
exceeding exports. Between 1996 and 2004, the U.S. current account deficit increased by $650
billion, from 1.5% to 5.8% of GDP. The U.S. attracted a great deal of foreign investment, mainly
from the emerging economies in Asia and oil-exporting nations. The balance of payments
identity requires that a country (such as the U.S.) running a current account deficit also have a
capital account (investment) surplus of the same amount. Foreign investors had these funds to
lend, either because they had very high personal savings rates (as high as 40% in China), or
because of high oil prices.
Neo-liberalism” and “globalization” are new terms for policies and tactics the capitalists
and their governments have always used to attack working people in order to increase profits.
For example, capitalists have always spread their system around the globe in order to exploit
raw materials and cheap labor and to control trade routes and new or established markets.
Chasing cheap labor around the globe and using cheap immigrant labor in order to get around
labor organizing.
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Under “globalization” with the use of new technology the exploitation of cheap labor on
a world scale intensified, sped-up in real time, and reached further distances. But the essence
of globalization has always existed under capitalism. For example, the collapse of Stalinism in
the Soviet Union and Eastern Bloc countries also breathed some new life into neo-liberalism
and its offshoots, like globalization. Stalinism left in its rubble new areas of cheap labor to
exploit and new parts of the globe to tear up and pollute.
From the mid-1970s up through today, working class wages and social conditions
inevitably worsened under this worldwide neoliberal attack. In order to maintain demand, the
ability of masses of working people to consume while their wages were stagnating or falling,
the capitalists began a massive expansion of credit. This included every aspect of individual
debt, from credit cards to car loans to house mortgages. Also, macroeconomic policies steeped
in borrowing, like international currency speculation and financial market deregulation, were
brought to new international heights. Government deficit spending reached record levels.
As a result, the development of the U.S. housing bubble and housing bubbles in other
countries spurred on by the fact that the vast majority of working people could no longer afford
to buy a house due to wages stagnating or falling.
Credit default swaps (CDS)
Under a CDS, a bank originates loan to a company. A second bank (or other financial
institution) can agree to cover the credit risk for the loan, by agree to make payment to
originating bank if the company defaults on the original loan. The originating bank pays a small
insurance premium to the second bank for assuming the risk of the loan. Typically, payments
under a CDS would only be triggered by the company's failure to pay interest or principal on its
debts due to bankruptcy or some other severe liquidity issue.
Actually, bank traders sold the credit risk of a loan not just once, but as many as 10
times. And they sold it not to solid banks and insurance companies, but to three solid banks,
one solid insurance company, three dodgy brokers and three hedge funds. But since it
probably hedged those positions against others, if the company does go bust, and dodgy
brokers and hedge funds stop paying up, the total losses in the system from that company's
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credit risk are likely to be a substantial multiple of the original $10 million loan. The total credit
risk in the system has been increased from the original $10 million loan to somewhere between
$160 million to 200 million, depending on whether the banks and insurance company are
financially solid.
4.2 The effect towards Caribbean
Financial Sector
The financial sector in the Caribbean is quite insulated from the current global crisis, partly
because it is small and underdeveloped and so mortgage backed securities were not dumped
onto their market by the USA investment banks. But in the case of AIG there can be said to be
a direct connection, since that firm has insurance and re-insurance coverage for a number of
products and services in Jamaica and Trinidad and Tobago, inter alia. However, the massive
loan by the USA Government may serve to keep AIG afloat, although customers may be asked
to pay a higher premium. Merrill Lynch the manager of certain Caribbean pension funds (e.g.
that of the CARICOM Secretariat) which prompts the question as to whether the ‘minimum local
assets ratio’ regulation, a requirement for both prudential and regional capital market
development purposes, is still being respected by the institutional investors (including
insurance companies) in the non-commercial banking sector.
The commercial banking sector in the Caribbean is quite tightly regulated, particularly
since the occurrence of the decline in Jamaica in the 1990s. So the managers tend to be rather
risk averse during this time. At this moment, Caribbean have not sounded any serious problem
partly because the USA correspondent banks that handle their day-to-day dollar transactions,
being commercial banks rather than investment banks are on the greater of the crisis. But
according to the effect of financial sector in Caribbean, it would be fine if the regulators in the
Caribbean region follow the pattern of Jamaica and Trinidad and Tobago and decree that
commercial banks hold deposit insurance, moral hazard notwithstanding which is on the other
mean is without being affected or prevented by something.
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Economic growth
Economic growth in the Caribbean also is likely to be considerably lower than what it was in
2007. In 2007, the Caribbean Development Bank (CDB) had reported that economic growth
slowed in nine territories and accelerated in only four. so the whole of Caribbean, therefore,
economic growth fell from 6.9% in 2006 to 3.9% in 2007 refer to the result of rising oil and
commodity prices, slower growth by major trading partners, depreciation of the USA dollar and
the high cost of intra-regional travel.
Before the economic crisis happened, the Caribbean economies is the fastest growth
since the 1960s but the impact from meltdown in US financial system causes the economies of
Caribbean has change which can see from the slump in exports that happened in late 2008. In
first nine months of 2009, the falling of tourist arrivals has led to the contracting GDP in nearly
all countries, rising unemployment and declining government revenues. Other than that, the
investment activity has became plummeted that reflected in sharp reductions in foreign
investment flows and a downturn in the construction sector.
If the U.S economic fall it is give big impact to Caribbean economic and the financial
trauma affecting the US economy would have already plunged the Caribbean into an economic
coma. Even if the situation it is unlikely that this will happen. But the outward ripples of the
financial crisis in the US will cause an economic downturn in the Caribbean.
The US financial meltdown has its origins in what has been called the US subprime
mortgage crisis. Mortgage lenders made loans available to borrowers who would not normally
qualify for mortgages at market rates. These mortgages would typically have attractive, easy
initial payments but included adjustable rates of interest if the market changed. At a time when
housing prices were climbing, many borrowers took on difficult mortgages, thinking that as the
value of their homes increased, they could quickly refinance.
But once housing prices started to fall due to oversupply of housing stock, refinancing
became more difficult and the adjustable rates on mortgages kicked in, unleashing a wave of
defaults and foreclosures. The effects of this were felt beyond the borders of the United States
because the credit risk did not remain solely with US lenders but had been transferred to
investors all over the world.
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Flow of Remittances
With rising unemployment, falling house values and depreciation of other asset holdings,
remittance flows to the Caribbean are expected to fall considerably as a effect of the financial
crisis.
Because of the crisis some of the countries in Caribbean recoded that in 2007
remittances from the USA alone were cited as Jamaica US$1.9 billion, Haiti US$1.8 billion,
Guyana US$424 million, Trinidad and Tobago US$125 million, Suriname US$115 million and
Belize US$105 million. Remittances have become a crucial source of income for some of the
Caribbean countries. For example, in Guyana they represented 43% of the GNP, and in Haiti
35% and Jamaica 18%. These figures are likely to fall considerably for 2008 and the poor and
most vulnerable or easily effected segments of the Caribbean population are likely to be
severely impacted. Retail establishments and related consumption sectors will accordingly
experience a decline of activity.
Foreign Exchange Reserves
Caribbean Banks have about US$20 billion invested abroad as foreign exchange reserves. The
subprime mortgage crisis gives effect to the Caribbean Central Banks whereas, these
“sovereign wealth funds” earn income when invested in government bonds, corporate bonds or
equity and earnings have fallen as a result of the crisis. In the case of Trinidad and Tobago, the
reserves are said to be managed by a subsidiary of Lehman Brothers, which is a USA
investment bank that has filed for bankruptcy protection.
The crisis encourages reviewing of the Caribbean foreign exchange reserves holdings
strategy. The effect to foreign exchange whereas the Caribbean facing some questioning, first
should all of a country’s foreign exchange reserves be managed by one overseas investment
bank or be denominated in one international currency? And the second are the foreign
exchange reserves adequate in a world that continues to be rattled by recurring financial crises?
After the 1997-98 S.E. Asian financial crises, the Central Banks in the Caribbean region made
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a conscious or more alert attempt to increase their foreign exchange holdings above the
traditional three months import cover figure and some now have over five months import cover.
For example, Trinidad and Tobago, for its part, has also placed US$9 billion of its petroleum
and gas earnings into a Heritage and Stabilization Fund.
Undoubtedly after the housing bubble burst, the US construction industry that employs
a large number of Central Americans, notably Salvadorans, would experience a decline. The
percentage of Caribbean immigrants employed in the construction industry in the United States,
compared to Central Americans, is perhaps not that great.
Tourism
Tourism is the major income that contribute the GDP in their countries, in 2006 there are many
travelers come into Caribbean such as Bahamas, Jamaica, Guyana, Trinidad and Tobago but
due the effect from subprime crisis in US the Caribbean has faced uncertainty recession that
lead to reduced travel demand from that countries. The weakening of US dollar are tied with
currencies in Caribbean that lead to increase in travel demand from Europe because the euro
and sterling pound much stronger than dollar, however this may not be able compensate for
the loss from US market so as the result the Caribbean needs brace for the impact. Therefore,
a United States recession would undoubtedly be felt in Caribbean economies because it
reduced demand market from the market and negatively impact tourism and overall economic.
Other than that, the energy crisis and related high oil prices continue to cause serious
air-lift problems for the Caribbean tourism sector such as a collapse of certain airlines,
elimination of certain destinations, and reduction in the frequency of flights and increases in
airfares. In addition, there is the adverse effect of a reduction in the baggage allowance. The
situation is now further forced by the financial crisis with smaller number of persons being able
to afford holidays abroad. This coming winter season is therefore expected to be a rather
unwelcoming one for the hotel and entertainment industries.
A double unpleasing thing such as hurricane season is increasing trouble for the
tourism industry will come on top of the adverse impact of natural disasters whereas some
Caribbean countries have been experiencing this. So this encourage those who contribute the
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least to global warming are most adversely affected and the World Bank Grant Disbursing
Facility need to setting up of a disaster relief purposes.
The Caribbean economies fastest growth period since the 1960s has been rapidly
interrupted by the international economic crisis that began with the meltdown in the US
financial system. The impact on these countries is being felt through a slump in exports that
started in late 2008, and that situation makes falling tourist arrivals in the first nine months of
2009 that lead to contracting GDP in almost all countries, rising unemployment, and declining
government revenues. Investment activity has also plummeted, and is reflected in sharp
reductions in foreign direct investment flows and a depression in the construction sector.
Cost of Borrowing
The rate of interest is different among country so, there is a credit crunch in the markets of the
developed countries as loans are either not available or available at a rather high rate of
interest. In situation of Caribbean entities, whether government or corporate, that Caribbean
attempt to tap the international market, will face this kind of situation experience and it will be
more difficulty even for those have a very good credit rating.
However, because of this cost of borrowing Caribbean in recent years, Caribbean
Governments and corporate entities have been secure financing for an increasing proportion of
their debt from the surplus economy of Trinidad and Tobago, where the rate of interest,
moreover, tends to be lower than the international rate.
Foreign Direct Investment (FDI)
The crisis happened in US has effected in Caribbean financial institutions, their financial assets
are less risky than previous years. Besides, the continuous reduction in interest rates in US
makes the region attractive to capital inflows which raise the growth in asset prices. The
financial crisis worsen in United States would severely affect the global financial system
harming particularly the more financial services dependent Caribbean country. It also affect FDI
where the banks would be more reluctant to grant loans to multinational corporations and
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would result the increased uncertainty which make them less willing to invest, this condition
would give negatively affect the Caribbean countries.
The year 2008 is expected to show a decline in foreign direct investment (FDI),
particularly since the USA accounts for a large share of FDI in the Caribbean. Because of the
credit crunch (and fall in the level of economic activity) investors would not have the level of
capital or business confidence that would be required to engage in large projects of a natural
resource or hotel construction and infrastructure nature. One exception would be exploration
and drilling activity in the area of petroleum and natural gas. Accordingly, FDI in the Caribbean
in 2008 is likely to be less than the 2007 estimate of US$4.5 billion or the actual 2006 figure of
US$3.8 billion.
Although FDI per capita has been relatively high in the Caribbean, there is now need
for a redoubling of investment promotion efforts and greater geographical diversification of the
sources of investment inflows. In addition, intra-Caribbean investment should be more
vigorously encouraged.
The year 2008 is expected to show a decline in foreign direct investment (FDI) as
occurred after the 9/11 event in 2001, particularly since the USA accounts for a large share of
FDI in the Caribbean. Because of the credit crunch (and fall in the level of economic activity)
investors would not have the level of capital or business confidence that would be required to
engage in large projects of a natural resource or hotel construction and infrastructure nature.
One exception would be exploration and drilling activity in the area of petroleum and natural
gas. Accordingly, FDI in the Caribbean in 2008 is likely to be less than the 2007 estimate of
US$4.5 billion or the actual 2006 figure of US$3.8 billion.
Although FDI per capita has been relatively high in the Caribbean, there is now need
for a redoubling of investment promotion efforts and greater geographical diversification of the
sources of investment inflows. In addition, intra-Caribbean investment should be more
vigorously encouraged.
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Other Export Earnings
The intensification of the crisis adversely affects USA demand for Caribbean manufactured
goods whether these enjoy preferential market access (CBI/CBTPA) or not. The Caribbean
dollar tends to be tied to the USA dollar and so when the latter fell in the early stages of the
crisis Euro and Pound earnings from commodity (and tourism) sales to Europe partially
compensated; however, now that there is tending to be a currency realignment, this is no
longer the case. In any event, if the deepening of the crisis is prolonged, European demand for
our traditional exports (bananas, sugar, rice, etc) will fall, as well as demand by China, Russia,
etc for bauxite resources. Two other commodities worth mentioning are petroleum and gas,
and gold; Trinidad and Tobago’s earnings have fallen from the dizzying heights reached during
the energy crisis, whereas, Guyana and Suriname would have benefited from a rise in the price
of gold, a commodity to which speculators gravitate in times of financial crisis.
One other export adversely affected is that of capital. For decades, there has been an
unspoken low intensity flight of capital (‘reverse remittances’) to mainly the USA, Canada and
Britain by businessmen and individuals wishing to hedge their bets against socio-economic and
political instability in the Caribbean. Such holdings of stocks, bonds and real estate would have
experienced a drop in earnings during the crisis, although these assets are typically held for the
long haul and should eventually recover in value. Whether the capital flight slows down is left to
be seen.
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5.0 Conclusion
Even the subprime crisis originated in the United States but the consequences were felt and
slowdown the whole economic in the world even in the developing countries such as Caribbean.
These occurred at a time when developing economies have been enjoying years of good
growth and has involved in great depression because of impact from the subprime mortgage
loan in US. The crisis has shown how important credit and risk management institutions into
economic growth, the appropriate institutions for the correct functioning of the financial sector
and the international financial architecture for mitigating financial crisis.
Indeed, the US has introduced the appropriate countercyclical policies that will in all
likelihood reverse further declines in stock and housing prices and that will boost the
investment and growth. But usually, these depend on the act of national government and the
international community to interventions and using the fiscal stimulus packages that suitable
with the seriousness of the problem. In Caribbean there are some recommendations to avoid
the impact from US recession which is, the countries must explore alternative markets for their
main exports to soften the impact of reduced import demand from US and the Caribbean
governments need became proactive in creating sustainable employment opportunities, other
than that the diversification of foreign reserves by the region’s central and commercial banks
that means the reserves not only be United States dollar denominated but should consist of
combination other world currencies.
By the way, there are limitations of extant valuation models and the failure of regulators
to understand the implications of the changing environment for the financial system and there is
different design or approach to examine the subprime mortgage market meltdown from a
theoretical and practical perspective so these might cause the accuracy in the results of
research paper. So the role of government as the intervention is necessary and appropriate to
became as intermediaries in their country, the government should continuing build the
appropriate financial systems and keep working reforming the international financial system.
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6.0 References
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UNHABITAT. (2011). THE SUB PRIME CRISIS, the crisis of over-spending and over-supply. The Global Urban Economic Dialogue Series, 32, 1-22.
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