Strategic Asia 2009-10: Economic Meltdown and Geopolitical Stability

The Role of the United States inInstigating the Global Financial Meltdown

executive summary This chapter reviews the causes and development of the global financial crisis and outlines three main challenges to constructing a global financial system that is less vulnerable. main argument: The global financial meltdown, which has led to the most serious worldwide recession since the 1930s, has its origin in excesses in the U.S. housing and mortgage markets. Millions of mortgage loans were made to home buyers who proved incapable of meeting their debt obligations. These mortgages had been pooled into securities that were later bundled into collateralized debt obligations and then sold to an international clientele of banks, insurance companies, hedge funds, and other investment institutions. Many of these buyers inappropriately relied on credit ratings based on flawed methodologies. Official financial regulatory institutions were largely passive onlookers and did not take preventive steps to protect the financial system. After the housing bubble collapsed, a more generalized process of deleveraging led to the failure or near-failure of a number of large financial institutions. For over two years, policy actions—first to counteract the seizing up of liquidity and later to deal with the threatened insolvencies— have struggled to keep pace with the escalating crisis. policy implications: The financial regulatory framework committed to by the leaders of the G-20 will need to meet three challenges: • identifying early warning signs of excessive credit creation • changing global financial supervision and regulation to avoid excessive leverage, capital inadequacy, and weak risk management • equipping the system to cope with useful but potentially explosive financial innovations Achieving these goals will take time and require difficult political compromises. United States The Role of the United States in Instigating the Global Financial Meltdown Roger M. Kubarych The worst worldwide financial disturbance and global economic downturn since the 1930s had its origins in the United States. In the beginning, the crisis involved the interconnections between the mortgage and housing markets. The mortgage market represents the single largest segment of U.S. credit markets, dwarfing even the U.S. government securities market. The housing market is the segment of the economy most heavily dependent on debt financing. Any understanding of how the crisis got underway must start with a careful look at what went wrong in this arena. More broadly, however, the role of excessive leverage in the financial system must also be explained. Aggressive leveraging was not confined to the mortgage market; far from it. In fact, it is impossible to grasp the scope of the financial market disturbances, the speed of their transmission internationally, and the painful process of overcoming the adverse consequences without looking closely at the role of securitization, financial derivatives, and a woefully inadequate structure of supervision and regulation of financial institutions and markets. This chapter overviews these dynamics and argues that, in order to prevent a recurrence of the global financial crisis, the leaders of the group of twenty (G-20) will need to ensure that their proposed financial regulatory framework meets three challenges: (1) identifying early warning signs of excessive credit creation, (2) changing global financial supervision and regulation to avoid excessive leverage, capital inadequacy, and weak risk management, and (3) equipping the system to cope with useful but Roger M. Kubarych is Henry Kaufman Adjunct Senior Fellow for International Economics and Finance at the Council on Foreign Relations. He can be reached at . 40 • Strategic Asia 2009–10 potentially explosive financial innovations.1 Achieving these goals will take time and require difficult political compromises. The first section of the chapter overviews the U.S. mortgage market by tracing the boom and bust in the housing and mortgage markets, explains the securitization of the mortgage market, and then recounts the explosion of the subprime mortgage origination. A second section places the current crisis in historical perspective. This discussion is followed by a recounting of the milestones of the crisis and the policy response. A final section offers recommendations for avoiding a repeat of the current global economic meltdown. The U.S. Mortgage Market The Boom and Bust in the Housing and U.S. Mortgage Markets As a result of the unsustainable boom in U.S. housing markets, a massive contraction in activity has been underway since 2006, evidenced by plunging housing starts, depressed sales of new and existing homes, a steep rise in vacancy rates, and tumbling housing prices across the country. The consequences have been excruciatingly painful for homeowners, financial institutions, investors, and the economy at...