How The American Mortgage Crisis Spread To Europe

1727 words - 7 pages

During the 2000s, there were few national investment opportunities in Europe because of low interest rates that caused government bonds to produce low returns. The solution for European investors was to turn to America where they could buy mortgage-backed securities, an investment that was considered safe and that yielded higher returns than government bonds (Fligstein and Habinek, 2011). When the American mortgage market broke down it quickly spread to other countries, and the global financial crisis was a fact.

In this paper I will start off by explaining the background for the mortgage crisis in the US. Afterwards I will try to elaborate how this could spread across the world and make ...view middle of the document...

After the “dotcom” crash in 2000, the Federal Reserve lowered the interest rates to make sure that the lending would continue (Fligstein and Goldstein, 2010). Houses were looked upon as a secure investment, so when the market for prime mortgages started to dry up in 2004 financial institutions gave subprime mortgages to households with low income and an unsecure ability for future payment. The conditions for the loans were to give the borrower a low rate for the first two years, and than highly increase it to compensate for this over the next years. The security of the mortgages was in the value of the house in a marked with prices that were unrealistically high. When housing appriciation decreased it caused problems for people stuck with mortgages they were not able to pay (Fligstein and Habinek, 2011). The mortgages began to breach and many people walked out on their mortgages. This caused the housing prices to do an elegant u-turn and the value of houses decreased. The investment banks became buried in CDO’s that almost just consisted of worthless houses, a package that was not exactly an exiting object to sell. This caused the market for securitization to nearly die. Several financial institutions experienced great losses on their bonds, which made them more reluctant in lending out money. This made the interest rate increase and it became hard for investors to finance their investments (Blackburn, 2008).

How did it evolve into a global crisis?
In 2008 after several different financial institutions went bankrupt, the international monetary fund gave a statement that: “The world economy is entering a major downturn in the face of the most dangerous financial shock in mature financial markets since the 1930” (IMF, 2008). After 2001, government bonds worldwide gave low returns because of low interest rates. Especially in Europe there was a lack of attractive investment opportunities (Kamin and DeMarco, 2010). Government bonds in Europe were only paying 1-2% and banks did not want to invest in firms since they were not growing. When European investors discovered the American innovation of securitization applied to mortgages, they saw a solution to their problem.

European banks ended up buying mortgage-backed securities and collateral debt obligations for the same reasons as the American banks. These bonds had an AAA rating from the rating agencies in the US, which meant that they were considered safe. In addition to this they paid a 3-4% higher interest rate than the bonds issued by the government. European banks bought these bonds using cheap credit, so when the bonds turned sour, they experienced the same economic shock as the banks in the US (Fligstein, 2012). Both American and foreign investors were partially guilty in encouraging the housing bubble by demanding more mortgage-backed securities. Since the demand was bigger than the supply of healthy mortgages, banks started lending out subprime mortgages to people with low income...

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