Subprime Mortgage Crisis

The subprime mortgage crisis is an ongoing economic problem which became more apparent during 2007 and 2008, and is characterized by contracted liquidity in the global credit markets and banking system. The recession in the U.S. housing market, risky lending and borrowing practices, and excessive individual and corporate debt levels have caused multiple adverse effects on the world economy. The crisis has passed through various stages, exposing pervasive weaknesses in the global financial system and regulatory framework.
The crisis began with the bursting of the United States housing bubbleand high default rates on "subprime" and adjustable rate mortgages (ARM), beginning in approximately 2005-2006. For several years prior to that, an increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms.
However, once housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically, as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.
The mortgage lenders that retained credit risk (the risk of payment default) were the first to be affected, as borrowers became unable or unwilling to make payments. Major banks and other financial institutions around the world have reported losses of approximately US$435 billion as of 17 July 2008. Owing to a form of financial engineering called securitization, many mortgage lenders had passed the rights to the mortgage payments and related credit/default risk to third-party investors via mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Corporate, individual and institutional investors holding MBS or CDO faced significant losses, as the value of the underlying mortgage assets declined. Stock markets in many countries declined significantly.
The widespread dispersion of credit risk and the unclear effect on financial institutions caused reduced lending activity and increased spreads on higher interest rates. Similarly, the ability of corporations to obtain funds through the issuance of commercial paper was affected. This aspect of the crisis is consistent with a credit crunch. The liquidity concerns drove central banks around the world to take action to provide funds to member banks to encourage lending to worthy borrowers and to restore faith in the commercial paper markets. The U.S. government also bailed out key financial institutions, assuming significant additional financial commitments.
The subprime crisis has adversely affected several inputs in the economy, resulting in downward pressure on economic growth. Fewer and more expensive loans tend to result in decreased business investment and consumer spending. The initial leveling off in the housing market has become a downturn in many areas due to a surplus inventory of homes. The reduction and shift in demand versus supply has resulted in a significant decline in new home construction.
With interest rates on a large number of subprime and other ARM due to adjust upward during the 2008 period, U.S. legislators, the U.S. Treasury Department, and financial institutions are taking action. A systematic program to limit or defer interest rate adjustments was implemented to reduce the effect. In addition, lenders and borrowers facing defaults have been encouraged to cooperate to enable borrowers to stay in their homes. Banks have sought and received over $250 billion in additional funds from investors to offset losses. The risks to the broader economy created by the financial market crisis and housing market downturn were primary factors in several decisions by the U.S. Federal Reserve to cut interest rates and the economic stimulus package passed by Congress and signed by President George W. Bush on 13 February 2008. Following a series of ad-hoc market interventions to bail out particular firms, a $700 billion proposal was presented to the U.S. Congress in September, 2008. These actions are designed to stimulate economic growth and inspire confidence in the financial markets.