THE UNITED STATES SUBPRIME MORTGAGE CRISIS AND ITS IMPLICATIONS FOR THE CARIBBEAN

Introduction

The bursting of the property bubble - subprime mortgage crisis - in 2007 in the United States has engendered panic, recession fears and turmoil in the global financial system. Although the United States economy grew by 0.6 per cent in the last quarter of 2007, down from 4.9 per cent in the previous quarter, day by day worsening scenarios emerge, from escalating oil prices, to a depreciating dollar and financial institutions' bailout by the Federal Reserve. Many economists and policy makers share the view that a subprime-led recession - i.e. two consecutive quarters with negative growth - is inevitable and will be much deeper and longer than the 2001 dot-com downturn. Moreover, the critical situation of the financial system has driven some analysts to argue that should the monetary policy response fail to restore confidence among investors, the outcome would be the worst crisis seen since the Great Depression. This pessimism is not only among specialists. Indeed, in late March 2008 the Consumer Confidence Index in the United States recorded its lowest level since February 1992. A recession in the United States will undoubtedly have an important impact on the world economy, despite the continuous rapid growth experienced by emerging economies, particularly China and India. The purpose of this article is threefold: first, to characterize the current situation in the United States economy; second, to discuss the economic policy responses; and finally, to elaborate on how Caribbean economies may be affected.

The nature of the crisis

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.1 The epicentre 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. Most subprime mortgages have adjustable interest rates, with initial fixed low interest rates for two years and then higher rates that are reset every six months based on a benchmark interest rate such as the London Inter-bank Offer Rate (LIBOR). Low interest rates and excessive risk-taking by many weakly supervised financial institutions eager to grant loans largely contributed to a sharp increase in subprime mortgages from 2.4 per cent of total mortgage loans in 2000 to 13.7 per cent in 2006. This, in addition to increased speculative demand, pushed up house prices by 80 per cent during that period, an increase only observed in the immediate post-World War II period.

The rapid appreciation in house prices brought about steep realization of equity from properties which stimulated consumer consumption that makes up a massive 72 per cent of United States GDP. Consequently net equity extraction from residential property spiked from 3 per cent of disposable income in 2001 to 9 per cent in 2005.2 Once interest rates began to reset, mortgage payments increased - in some cases by 30 per cent - to amounts that many borrowers could no longer afford. By January 2008, the rate of delinquency on subprime mortgages had risen to 21 per cent. 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.download