English News Article

How the Economic Crisis started?

Done by: Shawn Lim

There are mainly two types of US banks, Investment banks and Depositary Banks. Usually, people would deposit money into their saving accounts when the economy is bad, and only invest in investments when the economy is good. But, In 1999 November 12th, the Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act, was enacted. This act allowed commercial banks and investment banks to consolidate, which means that customers could save and invest in the same financial institution, which would do well in good or bad economic times. So thus, when the act was enacted, most banks approved of it.

And, this was where all the trouble started. The government's bid to get more people to buy houses made the banks lower the amount which customers need to pay for the collaterals. Thus, much more people borrowed money to buy houses. And this became known as the Boom.

Lots of people want to buy houses; however demand was higher than supply, which resulted in the shortage of housing estates. The value of the houses increased when demand was higher and this led to investors contemplating that investments in properties sector would yield high returns, thus more investors invested in housing. With the value of houses constantly increasing, the mortgage soon increased proportionately with it. This led to people unable to pay their mortgages and defaulting on installments. Without the money collected from mortgages from most of its customers, the bank had to use its reserves to keep up with payment. Eventually, the bank would not have any more money and it would announce bankruptcy.

The main culprit is hedge funds coupled with leverage. They use money collected by collaterals to 'hedge' their investments using different methods to earn money. Hedge funds were a high risk type investment due to a lack of transparency and regulation, and they are used by amateur investors who are out to gain quick and easy money. This caused hedge funds to have the liability to have structural flaws that could be undisclosed to the normal investor. Furthermore, it makes it impossible to make a rational investment decision as it is impossible to accurately calculate the inherent risks involved in a certain hedge fund.

The process leverage is to loan money from a bank and use the money to buy cheap items and sell them at a higher price in bulk. It could also be used in investing, in particular, hedge funds. Due to this, if they repay the loan, even with interest, they would still make a compounded gain in money. However, this comes with its risks too. If the sale fails, they also end up with compounded debt.

The sub-prime mortgage crisis started with hedge funds. A sizable amount of banks started lending money to high-risk groups whom started buying houses with the loans. They used a portion of the loans to start investing in hedge funds to try and quickly earn the money back and return the loans. However, the mortgage loans started defaulting mainly because of the problem that some hedge funds investments had failed and banks were starting to panic. Too many houses became their assets and the prices were going down, causing more people to default their loans as they thought why they were overpaying their houses. Eventually, the housing bubble within the US broke, and therefore hedge funds collapsed along with the stock market. Ironic, what was supposed to ‘hedge’ risk became their downfall. The backlash triggered by hedge funds caused some banks to fail. This started the chain reaction that we now call the economic crisis.