Impact of Subprime Loans in US

Subprime Landings were the central cause of the crisis in the United States, which became apparent from mid-2007.

Amplified riskiness in “Securitization”: During 1990-2010; securitization was at its peak with the introduction of CDOs; hundreds and billions of dollars were flowing to the securitization chain which resulted in biggest financial bubbles in real estate and home prices almost doubled by the end of 2007, but in the process to reduce risks by using financial instrument (which is the combination of loans of different credit risks that are usually offered to investment banks by the lender; entirely based on credit default swap) the riskiness of securitized assets increased significantly.  

Increase in Overall Borrowings: People borrowed more against the inflated value of assets which also amplified the net lending made in the history of US; means: not only high level of debt but also more and more debt which cumulatively resulted in increased non-payments (default rate). In the process to finance the landings, the leverage of Banks also increased. Subprime loans initially gave opportunity to purchase homes which resulted in inflated prices of respective properties and latter led people to lose their homes due to lower prices as supply increased the demand (because of major defaults against the payments). Subprime loans initially, attracted first-time home buyers to purchase their homes using subprime loans. During 2008, the substantial home foreclosures resulted in a loss for most of families in US. Subsequently, homeowners faced the loss of their homes.

In view of the fact that, Insurance agency AGI started dealing in CDOs backed by subprime lending. As the ratio of nonperforming loans increased; it created substantial losses for AGI which twisted into a scenario where AIG (the worlds’ largest insurance Co.) collapsed and was bailed out.

Disturbances in Banking Sector: By the time, the problem of subprime lending in US spread out; the financial sector had consolidated itself into few gigantic firms whose failure threatened the whole system of economy.

Some of the institutions are as follows:

Financial Institutions: JP Morgan, Citi Group

Insurance Companies: AIG, MIBA, AMBAC

Rating Agencies: Moody’s, Standard and Poor’s, Fitch; made billions of dollars in rating riskier securities

Investment banks: GoldMan Sachs, Morgan Stanley, Lehman Brothers, Merill Lynch, Bear Sterns

• Collapse of market of CDO led the investment banks with tones of Loans and real estate;
• In March 2008, the Investment Bank Bear Sterns ran out of cash and was acquired for $2 per share by JP Morgan;
• Federal takeover of two giant mortgage lender (Fannie May, Freddie Mac.);
• Record losses of $3.2 billion for Lehman Brothers which caused stock prices to collapse Bank went bankrupt which ultimately caused collapse in Commercial paper market;
• After the default of major Banks (which were rated in “A” category), the various credit rating agencies lost their respective credibility and razed some serious queries on ratings;
• Various stock markets crashed which indicated that global crisis was in the process;
• GM and some other US firms which are considered to be as the pillars US economy faced bankruptcy;

• Europe was also affected; In February 2009, the unemployment rate in the United States and Europe rose to 10%;
•  The rapid loss of creditworthiness caused a sharp decline in transactions central banks to lower interest rates to historically low levels, to supply ample liquidity to financial institutions.

Major impact that this crisis left on the financial sector included the fact that this sector worked harder than ever to fight back and worked extremely well to improve Corporate Governance in the respective institutions to avoid any exploitation of resources as done during the crisis.

Conclusion:

“Financial development made the whole system riskier.”

By: IMF Chief Economist; Rughuram G. Rajan