Causes Of American Debt Crisis
There a series of factors which were the main causes of American debt crisis. While the
American have been actively encouraged to borrow by the financial deregulation policies of both central banks and governments, the impact of a collapsing credit bubble echoed around the globe, hurting the poorest most. Read on to know the main reasons for American debt crisis on this page.
Expansion of the housing bubble
The price of the typical American house increased by 124% between 1997 and 2006.
This encouraged quite a few homeowners to refinance their homes at lower interest rates, and take out second mortgages secured by the price appreciation. Although this collection of money roughly doubled in amount, income generating investments were not able to grow as fast. By 2003, the supply of mortgages initiated at traditional lending standards had been worn out. Continued strong demand for MBS and CDO began to drive down lending standards, and soon it was difficult to sustain this speculative bubble. By 2008, there was a decline of over 20% in the average U.S. housing prices.
Simple credit conditions
From 2000 to 2003, the Federal Reserve lowered the federal funds rate from 6.5% to 1.0% to reduce the effects of the disintegration of the dot-com bubble. These lower interest rates encouraged borrowing. The USA's high and rising current account deficit further pressurized to lower the interest rates as US required to borrow money from overseas. This developed a demand for different types of financial assets, thus raising the prices of those assets while reducing the interest rates.
2004-2006 saw a dramatic increase in U.S. Sub prime lending. Borrowers with weak credit histories with a greater risk of defaulting loan than prime borrowers, made good use of the easy credit conditions. This higher-risk lending also became one of the main causes of American debt crisis.
Another of the reasons for American debt crisis was predatory lending, which refers to the practice of dishonest lenders, to enter into "risky" loans for improper purposes. This resulted in negative amortization, which the credit consumer might not observe until long after the loan transaction had been accomplished. There is growing confirmation of such mortgage frauds to be a cause of the debt crisis.
Critics have debated that the regulatory framework did not keep up to the mark with financial advancements. The shadow banking system, derivatives and off-balance sheet financing were not given due importance. In many cases, laws were altered and enforcement made weak in parts of the financial system. Regulators and accounting standard-setters permitted the depository banks such as Citigroup to shift important amounts of assets and liabilities off-balance sheet into complex legal entities. These were among the main causes of American debt crisis
During the years preceding the crisis, the U.S. households and financial institutions became increasingly indebted and thus adding to their susceptibility to the collapse of the housing bubble, this only led to worsen the following economic downturn. Reports reflect how the free cash used by consumers from home equity extraction doubled from 2001 to 2005 as the housing bubble expanded. This is looked upon as one of the several reasons for American debt crisis.
Complexity in financial modernization
Use of the financial innovations like the adjustable-rate mortgage, collateralized debt obligations, credit default swaps and mortgage-backed securities expanded dramatically in the years thus, becoming the leading causes of American debt crisis. Varying in complexity plus the ease with which they can be valued on the books of financial institutions also had the effect of circumventing regulations.
Inaccurate pricing of risk
Another of the reasons for American debt crisis is that for different explanations, market participants did not precisely evaluate the risks intrinsic with financial innovations like MBS and CDO's. They failed to gauge its impact on the overall strength of the financial system. These practically unthinkable, losses had dramatic impacts on the balance sheets of banks across the globe, which were left with very little funds to continue their operations.