The American government unsuccessfully proposed a $700 billion plan to rescue the economy.
the Gauntlet

From Wall Street to Main Street

High-risk mortgages lead to stock market crash

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The American economy has been through a tumultuous fall. Many economists, journalists and politicians have described the crisis with varying degrees of fervour, but all agree that the situation is serious.

Calgary Economic Development vice-president and chief economist Adam Legge remarked that this autumn heralded the fall or take over of revered financial institutions like Lehman Brothers, Bear Stearns and Washington Mutual. These are companies that survived world wars, famines and even the Great Depression, but are now being toppled by the bursting of an enormous speculative bubble.

"They have seen the worst of the worst and now they are gone," said Legge.

The bubble was predicated on the idea that housing prices in the United States were going to rise indefinitely. It swelled because of extremely risky investments made by the financial industry that produced enormous short-term profits.

University of Calgary economics associate professor Dr. Frank Atkins suggested that the seeds of this crisis can be traced back to prolonged and artificially low interest rates set by the former federal reserve chairman Alan Greenspan in an attempt to bolster the economy after 9/11.

"When interest rates were really, really low and the U.S. economy had recovered, Greenspan, for whatever reason, kept them low," said Atkins. "This set the environment for individuals to get into the housing market when under normal circumstances, they wouldn't have been able to get in."

The practice of giving loans to people who could not afford them was accelerated by an immense amount of money floating around the world economy looking for safe and profitable investments.

National Public Radio program, This American Life, explored the connection between skyrocketing global wealth and the American housing crisis in an episode titled "The Giant Pool of Money." The program outlined how the amount of money the global economy was looking to invest has risen exponentially over the past few years. This dramatic increase was largely due to the rapid development of economies like China, India and Saudi Arabia. International business and economics correspondent for NPR Adam Davidson described the pressure placed on the world by a veritable army of nervous investment managers.

"The world was not ready for all this new money," he said on the show. "There was twice as much money looking for good investments, but there was not twice as many good investments."

American investment firms bought up mortgages from banks and brokers and then bundled thousands of them together, explained Davidson. The pile of mortgages collected a monthly income that would theoretically continue for the entire length of the mortgage. Investment firms then sold shares of this monthly income to investors known as mortgage-backed securities. They became extremely popular forms of investment and the financial system was pressured to come up with more and more of them. Eventually everyone in the U.S. who could afford a mortgage had one so the system turned to people who could not.

"They were actually loaning mortgages to people with no down payment, no assets and in some instances no income," said Atkins. "It was like a bonanza."

The mortgages were lent at an extremely high risk of default, but repackaged as sound investments. Huge profits were made at each link of the chain and those involved ignored indications of catastrophic long-term consequences.

When homeowners began to default on mortgage payments, the precarious nature of mortgage-backed securities was revealed and the speculative bubble burst leaving a gaping hole in the American economy. The U.S. government reacted by proposing a $700 billion bailout plan to staunch the bleeding. Economists were reluctant to see the government come to the aid of companies whose irresponsibility would be justly punished by market forces.

There is, however, general consensus that some action is necessary to prevent a domino effect and possible economic collapse.

"It will burden future generations with the cost of this generation's greed, but it will still be better for the next generation if the bailout happens," said Legge.

U.S. Congress rejected the bailout on Monday and the Dow Jones as well as Toronto's S&P/TSX composite took historic single-day plunges. There has been immediate pressure to resume efforts to draft another intervention strategy.

"No economic problems are insurmountable," said Atkins. "They will come out of this, the question is how long will the economy be dragged down. No one knows the answer to that and anyone who thinks they do is crazy."