A proposal to stop the fear-fear spiral

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Journal article

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The India Economy Review

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The “financial market tsunami” that rocked the world had its origin in the US housing market, and resulted from indiscriminate and excessive lending on one hand, and excessive leveraging among financial institutions on the other hand. Earlier on, the US housing market boom was driven by indiscriminate and excessive lending rather than by low interest rates. The indiscriminate and excessive lending reflected a moral hazard problem, as lenders believed that they shifted their risks to others or had protection against default through the widespread use of credit default swaps. Through securitization, mortgage lending institutions easily obtained more money to lend to homebuyers, as a result of which many of them became overly leveraged and thus more and more vulnerable. In point of fact, in the absence of excessive lending, really destructive bubbles could never form. If homebuyers had meager incomes, their limited ability to bid for homes means that homes could never be priced beyond their reach. The US housing bubble was in part a result of domestic politics that favored making mortgage borrowing available to those who could not afford it, and in part a result of a form of moral hazard: some financial institutions believe their lending is sheltered by Credit Default Swaps, so that they can lend indiscriminately, and mortgage brokers have little concern with repayment, since their immediate concern is to earn a commission. The reversal of US housing prices since 2006 was not unexpected, even though the extent of the decline was. Just as the housing bubble was caused by policy that mistakenly favored homeownership and ignored the dire consequences of excessive leveraging, so its collapse was triggered by excessive interest rate raises against a backdrop of dangerous leveraging.

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Recommended Citation

Ho, L. S. (2008). A proposal to stop the fear-fear spiral. The India Economy Review, 5, 156-159. Retrieved from http://www.iipmthinktank.com/publications/archive/ier/IER-dec-08.pdf