The Causes of Subprime Mortgage Financial Crisis

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The Causes of Subprime Mortgage Financial Crisis

By Jessica Tian

Abstract
The U.S. subprime mortgage crisis was a set of events that led to the 2008 financial crisis, characterized by a rise in subprime mortgage defaults and foreclosures. This paper seeks to explain the causes of the U.S. subprime mortgage crisis and how this has led to a generalized credit crisis in other financial sectors that ultimately affects the real economy. In recent decades, financial industry has developed quickly and various financial innovation techniques have been abused widely, which is the main cause of this international financial crisis. In addition, deregulation, loose monetary policies of the Federal Reserve, shadow banking system also play dominant roles in this crisis. From the bankruptcy of Lehman Brothers, AIG, Washington Mutual Bank, government takeover a series of financial institutions, the world's major economies continued to fall. The direct consequence of this financial crisis will inevitably lead to the global economic downturn and even recession. Introduction

This paper has two sections. Section I gives an overview and background of the subprime mortgage crisis, the recent financial instruments and innovations, and how the crisis led to a generalized credit crisis in the financial industry. Section II discusses the causes of the crisis, including deregulations, loose monetary policies and so on. 1. Background and Financial Derivatives

1.1 Housing industry and subprime mortgages
Some years before, the U.S. housing mortgage party was prosperous, investors and mortgage bankers made millions, even billions from this party, which may due to the low interest rates. In the wake of the dot.com bust and 9.11 disaster, the U.S. Federal Reserve Chairman Alan Greenspan lowered interest rates to only 1% to keep the economy strong, which is a low return on investment that led investors to seek for better investment opportunities. So the investors turned into the housing industry. Wall Street earned $27 billion in revenue from selling and trading asset-backed securities (Farzad, 2007a). Many middle class families saw their home equity rise and felt rich. Even those from lower classes were able to own houses with minimal or even zero down payment. As house prices rose, every people had a good time. The house prices in the U.S. shot up 40% between 2000 and 2006 to a high of $234,000. However, the housing bubbles burst and house prices started to decline by early 2006 and are expected to fall sharply in 2007 and 2008. Accordingly, defaults and foreclosure rates began to increase. In 2006, 1.2 million household loans were foreclosed, up 42% from the previous year. It is expected that two million homes will be foreclosed on in 2007 and even more in 2008 when 2.5 million adjustable rate mortgages will reset higher (Schwartz, 2007.). Subprime mortgages simply mean lending money to house borrowers who with irresponsible credit. Lenders did so by providing homebuyers minimal or zero down payment, do not need home owners provide proof of, no documents, and weak credit checks. Between 2004 and 2006, $1.5 trillion of subprime mortgages were booked. Total subprime loans from 25% of the housing mortgage market (Capell, 2007.). These subprime loans were fine as long as the housing market continued to boom and interest rates did not rise. If these conditions vanished, the subprime borrowers may default. These defaults had negative influence of the mortgage backed securities (MBS), the collateralized debt obligations (CDOs) and credit default swap (CDS) market, which soon had detrimental impacts on everyone. 1.2 Mortgage Back Securities (MBS)

Building on the definition of a bond, a mortgage-backed security (MBS) is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization (Wikipedia). Securitization enabled banks and mortgage companies who are the originators of...
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