A Report on the Subprime Crisis in USA (2007-08)

Easy availability of low interest mortgage loans, miscalculations on the part of rating agencies, highly unrealistically priced houses and last but not the least, indiscriminate issuance of subprime loans to people with a bad credit score (FICO scores below 620) were the major factors that formed the basis of the subprime crisis in the US. Throughout the first five years of the twenty first century the prices of homes (an integral part of the American dream) in USA were on the rise. This resulted in the construction of disproportionately higher number of houses than their realistic demand.

This boom in house construction was facilitated by the fact that the US saw a huge amount of money flowing into the economy towards the end of the century leading to a high amount of liquidity in the economy. Low interest adjustable rate mortgage loans were easily available, and bad loans, which are characteristically high yielding investments, were given on a large scale. In fact, only 5% of total loans in 1994 were bad loans, which grew to 21% by 2004. The banks sold these mortgages to various financial institutions (in order to get cash to make other loans) such as Fannie Mae (FNMA) and Freddie Mac (FHLMC) which in turn created Mortgage Backed Securities – a bond-like security created by pooling different mortgages of a similar kind (to distribute the risk on the investor) and sold these to investors, thereby creating a cycle which facilitated more mortgages. These securities were given (allegedly paid) high ratings by firms such as Moody’s and S & P, which led to these being regarded as stable investments. It was around 2006-07 when the housing bubble started to burst resulting in an increase in the adjustable interest rates and the inability on the part of the borrowers to either repay the loans or get them refinanced.

In other words, subprime borrowers started defaulting on their loans. Even though the banks started acquiring foreclosure on the houses, the absolute value of the loan could not be recovered as the banks were holding assets people did not wish to buy. With this, companies started to register huge losses. The long list of companies which failed included Bear Stearns (2008, acquired by JP Morgan), Lehman Brothers (late 2008, filed for bankruptcy) and AIG (79.9% stake bought by the Federal Reserve).

All of this took a heavy toll on the credit market of the US. Unsure of the values of their current assets and the economic environment, the banks stalled lendings, leading to a liquidity crunch affecting economies worldwide. Quite simply, the shortage of loans led to an acute shortage of demand and investment in the economy leading to a recession. Overall the crisis led to the shutting down of over a hundred subprime mortgage lenders. Housing prices fell by over 30% from 2006 to 2009 and unemployment rate rose to a high of 10% in 2009. The crisis was a lesson for the lenders- to make sure that poor lending does not reach such a high level; for the credit rating agencies – that if they take payments in return for showing high ratings, it is their credibility that gets affected in the long run, and for the consumers at large – that unnaturally high debt can lead to economic hazards.