Serena Williams | Cause of the subprime mortgage crisis and its effect towards Caribbean

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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

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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

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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

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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)

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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.

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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

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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

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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)

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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,

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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

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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

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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

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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

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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

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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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IMPLICATION FOR THE CARIBBEAN. Economic Commission for latin and the Caribbean (ECLAC), 21, 1-11.

Jacob, M. A. a. D. (2008). The Sub-prime Problem: causes and lessons. Adelson & Jacob

Consulting, LLC, 8, 1. Kamin, S. (1999). The current international financial crisis: how much is new? Board of

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Michel G. Crouhy, R. A. J. a. S. M. T. (2007). The Subprime Credit Crisis of 07. Credit Crisis. Naude, W. (2009). The Financial Crisis of 2008 and the developing Countries. World Institution

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what to do about it: Princeton Univ Pr. Spiegel, A. K. R. a. M. M. (2009). CROSS-COUNTRY CAUSES AND CONSEQUENCES OF

THE 2008 CRISIS: EARLY WARNING. NATIONAL BUREAU OF ECONOMIC RESEARCH, 55, 10.

Stiglitz, J. E. (2009). The current economic crisis and lessons for economic theory. Eastern

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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.

Vukovic. V. (2010). Political economy of the US financial crisis 2007-2009. Financial Theory and Practice , 1-18.

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