Financial Crisis

Only available on StudyMode
  • Download(s) : 81
  • Published : April 24, 2013
Open Document
Text Preview
United States Financial Crisis
The Crisis
In late 2007, the United States experienced what some people call, “The Great Recession.” It has been deemed the greatest recession since the great depression of the 1930’s. The definition of a recession is two or more consecutive quarters of negative economic growth. Relating to GDP, this means a decline in GDP for two or more consecutive quarters. Due to the recent financial crisis, the United States suffered a recession lasting approximately a year and a half; December of 2007 through June of 2009. During this period, GDP dropped by an annual rate of 3.5%, from $14.41 trillion to $13.88 trillion. Technically, the recession ended in June of 2009, but the country had taken a huge hit and still faces repercussions of the crisis today. This paper will discuss the events leading to the financial crisis and the policy responses the government implemented in order to stop the crisis. Subprime Mortgages

Consensus says that the bursting of the housing bubble was the main cause of the recent economic crisis here in the United States. A main component of the housing bubble bursting was mortgage companies issuing subprime mortgages. This meant that people who had no business buying houses were approved by mortgage companies for loans. The issuing of these risky mortgages began in 2003. Everything seemed okay for a while, as people were able to live the “American dream” of owning a home. But borrowers were really relying on the notion that housing prices would continue to rise, and if they couldn’t afford payments anymore, they could sell their home and be fine. Mortgage companies used this concept to reassure less credit worthy borrowers. Adding to the problem was that most of these subprime mortgages were adjustable rate mortgages(ARM). This meant that the interest rate borrowers were paying could be changed at the lenders discretion. All of these things inflated the housing bubble. In 2006, when housing prices began to decline, this bubble finally popped, creating a giant mess. Lenders increased interest rates as housing prices decline. This left borrowers with mortgage loans that greatly exceeded the value of their homes. Borrowers lost the incentive to keep making mortgage payments, leading to a foreclosure epidemic at the end of 2006. By 2008, average housing prices had dropped by 20% from 2006. The country was sitting on approximately 2.3 million foreclosed properties. By 2009 14.4% of all U.S. mortgages were delinquent or in foreclosure. Financial System

The high amount of mortgage defaults sent a shock through the financial system. These defaulted mortgages were packaged into what are called mortgage-backed securities (MBS). The mortgage backed securities are then placed into rating pools based on the riskiness of the security. This process is known as securitization. These MBS’ are then sold in the investment market to investment banks and intermediaries. Essentially, purchasing a mortgage backed security is lending money to homebuyers. Mortgage companies and banks merely serve as the middlemen in the process. When all of these mortgages defaulted, the investment banks took a big hit, as they were the ones purchasing the mortgage backed securities. Lehman Brothers, who at one time was the fourth largest investment bank in the U.S., was a big holder of MBS’. Unfortunately for them, many of their MBS’ happened to come from the lower rated tranches. On September 15, 2008, Lehman Brothers filed for Chapter 11 bankruptcy.

The defaults in the mortgage market extinguished the trust between financial institutions. Ultimately, this resulted in credit markets freezing, such as the commercial paper market. This created a major issue, not just for the financial institutions, but for non-financial companies. The commercial paper market allows companies to receive short term loans from corporations in order to meet short term debt obligations, necessary for a company to operate. When...
tracking img