The United States Debt Crisis - Essay Example

The debt/equity ratio increased from 15:1 to 30:1 after the US Securities and Exchange Commission allowed shadow banks to borrow as much as their risk management departments considered prudent.

So while commercial banks formed only 40% of total lending, shadow banks accounted for almost 60%. Banks borrowed a ton of money, made great deals, and grew tremendously rich. They then paid back the borrowed money. Investors saw this and wanted a part in it. This gave banks the idea to connect investors to homeowners through mortgages.

Because real estate had been doing so well, investment banks were interested in buying the mortgage. The lender agreed to sell it to them for a fee. The investment banks then borrowed heavily, bought more mortgages, and collected them in a box.

The bank then cut the box into 3 slices: Safe, Okay, and Risky. It packed the slices back up and called it a Collateralized Debt Obligation (CDO). A CDO works like three layers. As the money comes in from homeowners paying off their mortgages the top tray fills first then the rest goes into the middle and the remainder goes into the last tray.
If owners are unable to pay their mortgages, fewer payments are received and the last tray remains empty. For taking more risk, the lowest tray receives a higher rate of return as compared to the first tray which receives the lowest rate as it is the safest. Banks insured these slices for a minor charge called a Credit Default Swap (CDS). Credit rating agencies rated the top as a safe AAA investment and the middle as BBB. Because of the ratings, the investment banker could sell the slices to investors with different risk preferences. They made millions through this, and then repaid the loans. Since investors were making a lot more than 1%, they wanted more CDOs, investment banks wanted more mortgages and the demand for mortgages rose.

They then approached the subprime market because if the homeowners defaulted on their mortgage, the lender would get the house which would increase in value. They started giving mortgages without requiring down payments, proof of income, or any documents at all. These mortgages were Adjustable Rate Mortgages. The mortgage payments were attractively low during the initial period but they increased exponentially after the teaser period.

As a result, from 2004 to 2006, subprime mortgages accounted for approximately 1/5th of the overall mortgage market. Eventually, the subprime borrowers started defaulting after the teaser period. The bank that was now the owner of the house went into foreclosure and put the house up for sale. Eventually, more houses went up for sale.
Now there were so many houses for sale, increasing supply, and causing house prices to fall, rather than rise. This created a problem for homeowners who continued to make their mortgage payments. The value of their houses began to decline as the number of houses for sale in the market increased. People refused to pay their mortgages. Default rates increased exponentially and prices nosedived.

Consequently, the value of CDOs which were backed by these mortgages also fell. Investment banks tried to sell the CDOs but there were no buyers. Through CDOs, the problem spread to other financial markets. The problem was further compounded by CDS because sellers of CDS bought CDS from others to protect themselves.

The Secondary market for subprime CDO trading halted because of a lack of buyers in the market. Private financial institutions refused to lend any cash which was already scarce. This was due to the loss of trust and the fact that no one could be sure that the borrowers were being honest about their CDO portfolios. This was why credit markets dried up.
Insolvency resulted from these liquidity issues in September 2008 and private lending froze completely in many significant debt markets. The whole financial system was frozen.
Investment expenditure on residential structures, and business equipment, and consumer spending on durable goods began to decline. In 2008 consumer spending and GDP began falling showing signs of a recession. These financial and economic downturns in the US also had devastating effects globally because of financial and trade dependence.

Future Prospects and Conclusion

Recently, the US government raised its debt ceiling to $14.3 trillion. It appears that the US economy is heading toward a crisis similar to the Greek Debt Crisis with alarmingly high levels of government borrowing. (US Debt Clock)
The US debt ceiling has been raised 74 times, 10 of which have taken place since 2001. If the US government reaches the limit, it would not have the authority to borrow more. (CNN Money)

China will soon stop buying US treasury bills as it has realized the dangerous situation that the US economy is heading towards. A drop in the US treasury ratings and the US dollar will result in China diversifying away from the US government securities. China may also start investing in assets abroad to hedge against any losses due to the depreciating dollar. (Kitchen)
So the US government is seen to have two choices, either to raise taxes by some hundred billion dollars to earn revenue to cover its obligations and reduce its spending or admit that they have reached its limit and will ultimately default on some of its debts. (CNBC) Read More