All’s a Bubble

Due to the current US economy meltdown, most of us hear a lot of economic terms which we may not understand, specially the most commonly used term, subprime crises. This article will help the readers gain a better understanding of some of those terms. Sub-prime borrowers are the set of borrowers whose ability to repay is in doubt. These borrowers are not qualified for the market interest rates due to various risky reasons such as income level, size of down-payments or employment status.

The sub-prime lenders are the ones lending to these borrowers. Large capital inflows in the US from 2004-2007 created a surplus of the loanable funds in the market and the already volatile market was then being speculated on various issues.

The crises came into picture due to the downturn of the housing sector, risky lending and borrowing practices, and excessive individual and corporate debt levels.

The assets that the subprime borrowers mortgaged were traded as instruments in the securities market that came to be knows as Mortgage Backed Securities (MBS). If the housing prices sharply dive due to various reasons such as inappropriate interest rates, excessive supply during the boom period, inappropriate credit ratings, the investors in these securities obviously lose their money. The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), two large government-sponsored enterprises, are the two largest single mortgage backing entities in the United States. Between the two corporations, they back nearly half of the $12 trillion mortgages outstanding as of 2008.

Now what led the US banks to lend to the sub-prime borrowers? The crises relate to the unsustainable and unrealistic home mortgages. Studies reveal that in 2005, the increase in home equity loans was six times more than the increase in the real income (income adjusted for inflation). During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006. The financial institutions kept lending to the sub-prime borrowers deliberately because everybody gambled that the housing prices would keep rising. Hundreds and billions of dollars were disbursed in this gamble. Despite the lessons offered by the ‘real estate’ angles of the 1991 meltdown in Japan and 1997 meltdown in East Asia, virtually all American banks and financial institutions partied as if there was no tomorrow. Starting with Bearn Sterns on March 29, 2008, financial institutions started tumbling one after the other. The collapse of the Lehman Brothers on September 15, 2008 (also referred by some News channels as Meltdown Monday) is also a result of the sub-prime crises. The Seattle based Savings and Loan credit union Washington Mutual (WaMu) declared bankruptcy on September 25, 2008 and for sure this is no the end.

The tenure of George W. Bush who settled as the President will come to an end just from where it had started. Well really, what goes around comes around. In 2001 as well, the stock markets tumbled followed by 9/11 attack on the World Trade Centre (WTC) and would certainly leave the President in almost the same topsy-turvy situation the next year when his tenure would come to an end.

Sanjay Kataria

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