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What is The Subprime Mortgage Crisis

The Subprime Mortgage Crisis came about because of the boom and bust of the real estate market and the poor precautionary measures employed by the lending institutions. Around 2006 and before there was a boom in real estate in the United States, and many people were prompted by this trend to either buy or invest in real estate. Many people bought houses by becoming subprime borrowers, and the lending institutions lent them the money without taking any cash down payments, and also did not bother to check if these people could really afford the mortgage they were taking.

The lending institutions felt safe in the booming real estate market, and thought that even if the borrowers defaulted they could sell the properties at a good price and still make a profit with foreclosure. We can now clearly see that this was not the case as there was a steady decline in the real estate market and the resultant bust. This put the lenders in a quandary as many people were defaulting in their payment and the properties which were foreclosed could not be sold at a price which could even recover the lent amount, let alone any profit.

This created bad assets for the banks and other lending institutions and they lost confidence in the financial stability of each other. Banks and lending institutions borrow from each other and the rate of interest is decided by LIBOR. This rate increased dramatically due to the panic and banks were not able to borrow from each other. 80% of the mortgages which were issued were adjustable-rate mortgages which means the rates can be reset with the change in economy. Due to the increased rates set by LIBOR, the rates of these mortgages skyrocketed. This in turn had the effect of more mortgage delinquencies.

The subprime mortgage delinquencies had a major impact on the economy of the whole country. This can be seen by the fact that majority of the country’s hedge funds had invested heavily in mortgage-backed securities. The defaults caused the price of these securities to go plummeting. Secondly hedge funds themselves can borrow money to make the investment by the use of derivatives. By this we can only gauge the magnitude of the loss suffered by these funds. These losses caused the Dow Jones to plummet dramatically, and there was widespread panic in the stock market.

The crashing stock market created further panic among investors and people were afraid of making any investments or even deposit money in banks. This created a shortage of liquidity in the market and the cash flow was drastically curtailed as everybody was hoarding. This of course created further economic complications and the result was a full scale recession.

It is interesting to note that the US economy could be so interlinked with real estate and its fluctuation could hit the overall economy so drastically. The subprime mortgage crisis had a deep impact not only on the US economy, but on the economy of the whole world.

Tags: bank, cash, check, liquidity, market, money, mortgage, price

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