The Ultimate Fall out of the Subprime Crisis - Term Paper Example

The Ultimate Fall out of the subprime crisis Subprime mortgage crisis are considered as one of the most serious economic crisis of the century as this crisis produced impact on many other important economic variables hence indirectly affecting the whole economic system not only of the United States but of other modern countries also, most importantly UK. "Sub-Prime lending typically has been characterized as lending at relatively costly interest rates and fees to credit impaired or otherwise high risk borrowers." (Lax, Manti, Raca, & Zorn, 2004). Thus subprime mortgage lending started out of the imprudent and relatively high risk high return lending decision making because bankers in order to earn more started to bet on something which had the potential of providing higher returns. Capitalizing on the exapnsionary monetary policy of the FED, banks and financial institutions started to look for other opportunities where the rate of return is higher as the prime rates in the country plummed to 4% only.(Murali, Muralikirishin & Yellavalli,2008). However, what was more innovative in this whole episode is the fact that banks in order to hedge themselves against the high risk lending through secrutization. Securitization is a process of bundling or pooling the non-liquid assets into marketability securities. The idea is to recoup the liquidity lost through the sanctioning and disbursement of the loans to subprime borrowers.(Hunton & Williams LLP,2005). There are various ways through which the securitization can take place. Most of the times, financial institutions did so by creating Special Purpose Vehicles in order to enjoy off-balance sheet accounting not only to strenghten their balance sheets but keep the garbage out of it. The problem started when the subprime borrowers started to default on their repayments. These defaults created a chain reaction of events which first overtook the banks but subsequently created further economic problems for the economy. The above graphical representation suggests the two traditional models of the mortgages and how default in both the models can trigger further damage.1 Technically subprime mortgages become a problem when at the default of the payments by the borrowers; financial institutions face a mismatch in the cash flows. As defined earlier that most of the financial institutions attempted to regain the lost liquidity through securitization by creating mortgage backed securities to match the cash inflows from the mortgage payments with the cash outflows from the payments to be made against those mortgage backed securities. When the inflows stopped due to default by the subprime borrowers, financial institutions, in order to keep their ratings intact, started to pay out for their obligations out of other resources. This than started to create a credit crunch in the economy as those resources which were technically should have been used in more productive resources were being utilized in repayment of the mortgage backed securities. Thus the available credit to the organizations and firms decreased and hence their output and productivity level started to decrease which slowly and steadily put pressure on various other economic pressures and hence started one of the worst economic crisis of the century. It is believed that the subprime mortgage in United States stand at almost $1.3 trillion however it only comprises a small portion of the US GDP and many believe that at such small magnitude level, it may not impact the US economy as such. (Ramady, 2008). The future seems to be more bleak as one half to two thirds of the subprime loans are Adjustable rate mortgages means that the interest rates on those mortgages are going to increase when they fall due therefore there are estimations that more defaults are yet to come as at higher interest rates, the subprime borrowers may face further hardships to payback their due installments therefore it is feared that crisis are going to further aggravate rather than subside until and unless Federal Reserve Board (FED) does not intervene into the issue. In order to assess the ultimate fall out of the subprime mortgage crisis, there are various elements which need to be taken care of in order to clearly outlining the same. OECD, in 2007, provided an estimate of the $ 300 Billion losses in terms of the subprime mortgages as well as Alt-A mortgages.(Wignall, 2008). These estimates are now believed to be on the lower side as the subsequent data suggested a harsher picture of the crisis. The ultimate hit has been taken by the Citibank which recorded the largest single amount of loss in its entire history when it declared a loss of $ 18 billion whereas Merrill Lynch posted $9.8 Billion in losses and a further write down of $ 16.7 Billion suggesting that the organizations are feeling the heat of the crisis and are finding it difficult to cope with the crisis. (Martens, 2007). Thus the ultimate fall out of this crisis can be multiple in nature as it has showed up in the form of different economic variables. First the credit crunch which has reduced the amount of credit available to firms who rely on the financial institutions to meet their working capital requirements, secondly a default from the borrowers means financial institutions not only face liquidity problems but also losses. This could trigger a serious run on the banks because depositors may feel that their money has been channeled into something which is not going to provide them desired returns. Due to credit crunch, the interest rates have started to increase too as available funds are becoming less and less in supply. Higher interest rates also link to the inflationary pressures on the economy suggesting that the spending by the consumers may decrease due to high prices. Unfortunately the current energy crisis as well as the rising food prices suggest that the most modern and strong economies are not even able to survive the crisis and what can unfold would be another great depression to be faced by the whole world this time and not only the United States of America. References Lax, H., Manti, M., Raca, P., & Zorn, P.. (2004). Subprime Lending: An investigation of Economic Efficiency. . Housing Policy Debate. 15 (3), 533-571. Hunton & Williams LLP.. (2005). Securitization: An Introduction. Available: http://www.hg.org/articles/article_1122.html. Last accessed 05 August 2008. Murali, Muralikirishin & Yellavalli,. (2008). Subprime crisis and Credit Risk Measurement: Lesson learnt. Available: http://www.infosys.com/FINsights/Subprime-Crisis.pdf. Last accessed 04 August 2008. Ramady, Mohamed A. . (2008). US Subprime Market Tsunami - The Fed Is Worried. Available: .. Last accessed 04 August 2008. Wignall, Adrian Blundell. (2008). The Subprime Crisis : the size, deleveraging and some policy options. Available: http://www.oecd.org/dataoecd/36/27/40451721.pdf. Last accessed 04 August 2008. MARTENS, PAM. (2007). The Toxic Giant and It's Own Black Hole:Wall Street Metes Out Street Justice to Citigroup.. Available: .. Last accessed 03 August 2008. Read More