So what has caused this major economic upheaval in the world? What is the cause of falling share markets the world over and bankruptcy of major banks? In this article, I shall try to explain the reasons for recent economic depression for all those who find it difficult to understand the complex economics lingo and are looking for a simple explanation.
It all started in US...
In order to understand what is now happening in the world economy, we need to go a little back in past and understand what was happening in the housing sector of America for past many years. In US, a boom in the housing sector was driving the economy to a new level. A combination of low interest rates and large inflows of foreign funds helped to create easy credit conditions where it became quite easy for people to take home loans. As more and more people took home loans, the demands for property increased and fueled the home prices further. As there was enough money to lend to potential borrowers, the loan agencies started to widen their loan disbursement reach and relaxed the loan conditions.
The loan agents were asked to find more potential home buyers in lieu of huge bonus and incentives. Since it was a good time and property prices were soaring, the only aim of most lending institutions and mortgage firms was to give loans to as many potential customers as possible. Since almost everybody was driving by the greed factor during that housing boom period, the common sense practice of checking the customer's repaying capacity was also ignored in many cases. As a result, many people with low income & bad credit history or those who come under the NINJA (No Income, No Job, No Assets) category were given housing loans in disregard to all principles of financial prudence. These types of loans were known as sub-prime loans as those were are not part of prime loan market (as the repaying capacity of the borrowers was doubtful).
Since the demands for homes were at an all time high, many homeowners used the increased property value to refinance their homes with lower interest rates and take out second mortgages against the added value (of home) to use the funds for consumer spending. The lending companies also lured the borrowers with attractive loan conditions where for an initial period the interest rates were low (known as adjustable rate mortgage (ARM). However, despite knowing that the interest rates would increase after an initial period, many sub-prime borrowers opted for them in the hope that as a result of soaring housing prices they would be able to quickly refinance at more favorable terms.
Bubble that burst...
However, as the saying goes, "No boom lasts forever", the housing bubble was to burst eventually. Overbuilding of houses during the boom period finally led to a surplus inventory of homes, causing home prices to decline beginning from the summer of 2006. Once housing prices started depreciating in many parts of the U.S., refinancing became more difficult. Home owners, who were expecting to get a refinance on the basis of increased home prices, found themselves unable to re-finance and began to default on loans as their loans reset to higher interest rates and payment amounts.