U.S Sub Prime Crisis

Introduction

            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.

Conclusion

          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.

Bibliography

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Sub prime Crisis forces hand of Bank of England. Retrieved on 27^th June 2007 from http://www.iht.com/articles/2007/09/17/business/boe.php

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What is Sub prime Crisis? How to Solve the Subprime Crisis? Retrieved on 27^th June 2007 from http://missionisi.wordpress.com/2007/11/27/what-is-subprime-crisis-how-to-solve-the-subprime-crisis/

William, A, et al (2002) Some Loans are More Equal than Others. Third Party Originations and Defaults in the Subprime Mortgage Industry. Real Estate Economics, Vol. 30, pp. 32