U.S Sub Prime Crisis
- Pages: 9
- Word count: 2106
- Category: Crisis
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Sub prime crisis is conventionally a strong economic aspect operating within the financial and real estate levels of economic variables. Its operating parameters are defined within the real estate market under controls of the standards and rates of making prime borrowings. However, economic diversity exists and holds between market interest rates and sub prime mortgage crisis. The next logical question is what is meant by the term sub prime mortgage crisis and what could be the possible reasons behind its effects?
Either, what is the economic rationale behind the crisis?
Overview of sub prime crisis.
By its definition, sub prime mortgage crisis implies the state with which a potential borrower who is in the real estate market have no substantial financial qualifications and abilities that adequately meet the standards held for prime borrowing. However, as taken to imply by many people, the crisis does not imply lower levels of interest rates conceived by the rates for prime lending. The starting point of the crisis was when below the levels of mortgage had a floating rate that was below the prime lending rates of the banks (Lawrence, 2007, p.67)
As an economic aspect, the crisis led to various states of market disequibrium especially in the U.S money market. Conventionally, sub prime crisis developed as an implication of loans that did not meet their “prime lending” guidelines. According to the U.S financial market, a “sub prime” is considered as a person with foreclosures of less than 620 and having mortgage loans or foreclosures that are far below the requirements of the financial market. It is a broad scope of crisis that is rooted on the fundamentals of U.S mortgage parameters (Steve, 2008, p.9) When mortgage borrowers who does not meet some a lending requirements are granted these loans, instability between the supply and the demand in the real estate develops. This is from the increased demand of real estates than the level of supply held by the economic structures which consequently increases their prices. Consequently the loanees face problems in the repayment of their mortgages.
Graph showing the cost of houses between 1976 to 2007 (http://seekingalpha.com/article/73552-the-impending-mortgage-crisis?source=side_bar_editors_picks)
Sub prime Lending
At one level, sub prime mortgages crisis is a liquidity issue that occurs from sub prime loan over-lending by the commercial banks. Within the market, sub prime refers to a conventional situation when the credit borrowing score/status of borrowers is below the ideal /required level to meet potentials for loan repayment (Bentom, 2003, 81). Therefore, the granted loan is unable to meet specific prime lending guidelines. It is also called
near-prime or B-paper lending which means giving out loans to persons who are unable to meet the existing conditions and requirements of the interest rates in the market (Ivory, 2007, p.4)
Economically, the crisis is risky both to the borrowers and lenders when the variables associated to the sub prime borrowers such as volatile financial situations poor/unworthy credit history and higher levels of market interest rates are combined.
Historical background of sub prime crisis.
The starting point of sub prime crisis was in 2006 when the sub prime lending reduced from 21% in 2004 to 9% in 2006. Behind the crisis was the aspect of securitizations which consequently increased levels of mortgage background securities (MBS). Additionally, various rating agencies started to assign various investment grading rates to the MBS (Martin, 2007, p.13). This led to public origination of highly risk in default loans which could easily be granted out following risk transfers between these securities. Despite the insight and adequate knowledge of high risk held by borrowers , lenders continued to grant huge loans that held high risk above giving them various incentives towards their increased borrowing levels (http://missionisi.wordpress.com/2007/11/27/what-is-subprime-crisis-how-to-solve-the-subprime-crisis/)
Graph showing the ratio of the household income to the price of houses in America (http://seekingalpha.com/article/73552-the-impending-mortgage-crisis?source=side_bar_editors_picks
Economically, real estate and homes were experiencing an increasing level of property value. With this motivation, owners of these estates used this increasing level in the estates to seek refinancing and consumption motivated borrowing from lenders. According to economic statistics, the prices for American homes increased by a margin of 124% between 1996 and 2006. With this as a financial motivation to the borrowers coupled with a basic assumption of an appreciating condition in house prices and easy credit worth from the lenders, they continued in increasing their borrowing levels. However, the levels of these borrowings were above what they could afford in their credit worthiness. Consequently, a state of depreciation in the U.S housing came in 2006 that found many home owners unable to meet their mortgage repayments (Chris, 2007, p. 6)
The early 2006 is referred as a historical period on sub prime mortgage market in the U.S when a “meltdown” in the industry surfaced in the economy. This was characterized by a highly increasing rate of foreclosures in sub prime mortgage. The same crisis led to the filing in bankruptcy of 100 prime lending institutions.
The falling lending companies led to a collapse of $ 6.5 trillion of various securities backed by mortgages (Ditrimis, 2006, p.6)
Substantially, the effects of this crisis were not only an economic problem in the U.S housing industry alone but the world as a whole. Various trading houses repackaged these sub prime debts into various attractive investments options and tools with banks shaping the securities held on the sub prime borrowers in Asia, U.S and European Markets. The Mortgage investors held in the crisis consequently ran in
Near-valueless investments when their securities were withdrawn by the tenders. Consequently, the level of lending between banks themselves and their borrowers reduced which led to the increase in interest rates and high cost in maintaining credit worth by borrowers in the financial market. To the general world , financial sourcing from U.S was also difficult which implied competitive disadvantages in their business competition lines (Kathleen, 2002, p.3)
Effects of the crisis
Sub prime mortgage crisis has had a wide framework to various economic, markets in the U.S and the world as whole. Predominantly, the impact of liquidity crisis is perhaps the biggest threshold that could be allied to the crisis (Ray, Dawn, 2007, p.46) The default crisis implied that investors stopped making money supply within the money market with which the lenders could certainly create more money through their lending behaviors. The lenders therefore could not create more money from the stoppage in their lending activities which earned them premium revenue on their repayments. Their was slow generation of “new financial business relations” between borrowers and lenders. The final results were higher interest rates in loans which were also unavailable for such poor credit worth and low equity borrowers (Bill, 2008, p.8) Consequently, this led to low liquidity levels in the financial market and therefore higher levels of costs related to investment. It can be concluded that the bench mark process guiding towards sub prime crisis was the economic boom in the U.S between 1996 and 2006 which gave a 124% in the value of the houses.
Alternative graph showing the annual growth in sub prime lending between 1994 and 2006. ( http://news.bbc.co.uk/1/hi/business/7073131.stm)
However, the crisis was responded differently by different financial institutions such as the Federal Reserve Bank, Bank of England and the ECB. Following , the liquidity crisis in its economy, the Federal Reserve bank injected huge sums of money which amounted to over $ 100 billion. This was part of the Federal Reserve Act of 1913 that allowed it to participate in various monetary policy aspects to govern the contemporary state of the economic situation in the country. At one level as the controlling tool in the money market, it had failed by failing to create an expanded eligibility in the financial collaterals, charging adequate interest rate as well as expanding borrowers eligibility in the financial discount window that provides regulation and supervision . To close up the deficit in the money market provided by the low supply the demand, it reduced its interest rate levels from 6.25% to 5.75 % in August 2007 which implied a consequent increase in borrowing by the commercial banks and other lenders from its reserves by $100 billion (Gregory, 2004, p.77)
As a monetary control tool , lower interest rate sought to lower the commercial interest rates by increasing the levels of money supply that were far below their level of demand. Elsewhere , commercial banks lending level in liquid finances was substantially declining as they held high valued assets but which were illiquid. However, the set of control response by the Federal Reserve was still detrimental because the commercial banks did not necessitate inability of borrowing at the original 6.25% discount window . Substantially, creation of more suitable collaterals would have served towards more expanded financial markets. Elsewhere, it should have included various financial instruments in the market pricing towards the most eligible levels of lending rates by the commercial banks (William, et al, 2002, p.32)
As a control tool also, the bank of England was positively motivated towards fundamentals of monetary tools that would safeguard towards sub prime crisis. Though undecided over what the crisis held in the Britain economy, the bank off England had to device various predatory tools and measures to help control the crisis in the U.S crisis. Substantially, it had to make emergency funding to the Northern Rock after its bankruptcy (http://www.iht.com/articles/2007/09/17/business/boe.php). Like the federal Reserve Bank, the Bank of England had failed to monitor the state of credit dispatch to the mortgage borrows from the commercial banks. Therefore Britain’s commercial banks had wrongly traded into sub prime mortgages.
Like the bank of England and the Federal Reserve the European Central Bank loaned out to various European Commercial banks to strengthen their creeping financial deficits that came from the U.S sub prime mortgages. With the blow in the financial markets in the U.S, investors had entered European markets for investments loans. Therefore, huge funds had moved out as capital outflows that left the money market at a deficit.
Though a complex aspect, sub prime crisis remains a fundamental economic aspect that affects the U.S and the entire world’s economy. It structures were primarily rooted on disequilibria between the long run supply and demand in the money market of different world economies. Generally, its impacts of a future occurrence can only be provided by a supportive and elementary monetary policy tools that safeguard between the levels of lending rates and the state of securities/collaterals. Subjectively, the government control over the nature of loan granting by the commercial banks should be aimed at ensuring the most eligible eligibility and the credit worth of the borrower.
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