In 2007, many banks in US and Europe were hit by a collapse of the value of mortgage-backed securities. The investment banks and brokerages lost $175 billion of capital between the periods of July 2007 to March 2008. JP Morgan Chase rescued Bear Stearns in March 2008 with the help of $29 billion of guarantees from the Fed. By end of January 2008, $75 billion of new capital had been injected into banks. In UK, the rising cost of liquidity destroyed the business model of a large mortgage house and the Fed dropped its interest rate by 75 basis points late January. Problems were already arising but it did not occur to the world that it was going to be so drastic. In July 2007, Deutsche Bank was forced to bail out two property-based funds. In October 2007, the US Treasury encouraged Merrill Lynch, Morgan Stanley and Bank of America to set up a $70 billion fund to help ease the value of the toxic assets – unfortunately that did not work either. By the end of 2007, the world’s central banks tried to pump in large amounts of liquidity into the global financial system. On 7th September 2008, James B. Lockhart III (2008) announced the decision to place Fannie Mae and Freddie Mac into conservatorship run by the Federal Housing Finance Agency. On 15th September 2008, Lehman Brothers filed for bankruptcy, which caused a series of drastic changes in the stock market. The subprime mortgage meltdown in the US created an economic tsunami that effectively froze the world’s credit markets.
The financial tsunami was triggered by a long period of global imbalances and asset bubbles. US Federal Reserve kept interest rates so low in 2001 - 2006 because of the fear of recession. However, this in turn made home loans cheap and easy which led to subprime mortgage crisis. Wikipedia (2010) describes subprime mortgage crisis as an ongoing real estate crisis and financial crisis triggered by a dramatic rise in mortgage delinquencies and foreclosures in the United States. Dodd (2007) said that approximately 80% of US mortgages issued in recent years to subprime borrowers were adjustable-rate mortgages. US house prices went up to its peak in mid 2006 and begin to decline thereafter causing refinancing to become very difficult. As adjustable-rate mortgages began to reset at higher rates, mortgage delinquencies went up. It caused a large decline in the capital of many banks hence causing a strain to the world’s credit.
The banks themselves borrowed to buy up subprime lenders. In order to limit their own exposure, they repackaged the poor debts into CDOs (collaterised debt obligations) and sell them to their clients. By doing this, banks and hedge funds had supposedly “insured” the risk. The main cause of the financial tsunami would be the bursting of the United States housing bubble. High default rates on subprime and adjustable-rate mortgages have caused a huge strain on the world’s finance. As interest rates went up and housing prices start to drop, refinancing became a serious issue.
The business model of Fannie Mae and Freddie Mac led to millions of Americans who had no means to finance their homes to buy houses on the assumption that housing values would keep rising. And on the other hand, lenders sought to reduce their risks and increase profits by rolling the mortgages into bonds. The MBS (mortgage-backed securities) were...