Global Implications of Economic Crises Essay

GLOBAL IMPLICATIONS OF CONTINUING ECONOMIC CRISES

PART A QUESTION 2:

“This crisis emerged from general business practices on Main Street as much as from financial practices on Wall Street. Demonizations of Wall Street just distract people from the systemic roots of the crisis”. Present an essay in which you argue for or against this quotation.

In this essay, we will argue for the quotation and explain how the subprime mortgage crisis emerged not only from financial practices but from general business practices as well. Therefore it created a global economic crisis rather than merely a financial one. The subprime mortgage crisis started in 2007 when the majority of American workers defaulted on their loans and mortgages. However the whole economy wouldn’t have collapsed if its stability wasn’t based on those massive loans. But how did this flawed system emerge? Wall Street’s financial speculation certainly played a key role in the bust of the housing bubble that led to the crisis. In fact, investment banks created new financial products, whose “safety” was meant to convince wealthy individuals, corporations and foreign governments to invest in: asset-backed securities (ABS) and mortgage-backed securities (MBS) diversify the risk since each security represents a fraction of the total value of the diverse pool of underlying assets. ABS and MBS therefore became the subjects of speculation as they were considered reliable investments. To mitigate the risk even further, insurance policies in the form of “credit default swaps” could be purchased with the ABS or MBS to cover a potential default of payment of the initial loan or mortgage that would result in a loss of value of the related ABS or MBS. The insurance company American International Group (AIG) was a major player in the spiral of speculation that took place as investment banks were taking bigger risks. However, Wall Street financial institutions were not the only participants in the accumulating speculation of debts. Rating agencies such as Standard & Poor’s, Moody’s, and Fitch played a very important role in the subprime crisis. Paid by the banks, they had the incentive to give high ratings to securitization transactions, thus encouraging a flow of investments into these risky products. As we can see, business practices of these rating agencies fostered the spiral of speculation that the financial institutions were engaged in. But this spiral of risky speculation would not have resulted in such a global crisis if the debt it was based on wasn’t the foundation of the whole American economy. Therefore the question is: who are the agents that participated in the creation of the initial unsafe economic environment – the debt – that was, according to the previous quotation, “the systemic roots of the crisis”? As we will explain, other non-financial practices converged leading up to the amassing of the debt, and this is precisely the reason why saying that Wall Street is solely responsible for the subprime mortgage crisis is wrong. Originally, the government played an important enabling role in spurring the housing bubble bust that eventually led to the collapse of the economy. In fact, unwise regulations allowed risky lending practices. First, the Community Reinvestment Act (1977) allowed commercial banks and loans associations to lend to low-income borrowers in order to reduce discriminatory credit practices. This encouraged commercial banks and private loans associations to lower their lending standards, so that people who normally would be rejected could borrow money. As a result, the ratio of lower-quality subprime mortgages rose from 8% to 20% between 2004 and 2006. Additionally, the Alternative Mortgage Transactions Parity Act (1982) allowed lending commercial banks to write adjustable-rate mortgages, thus giving license to higher risk mortgage products of all forms. As for any other business, profitability is the first concern for

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