The Subprime Meltdown - Essay Example

(Gordon, 2008). The less stringent regulations for financial sector encouraged banks and other financial institutions to go on lending spree by defying prudent lending practices and lend into those areas which were historically considered as bad credit areas. Subprime mortgages is also the part of same sequences under which banks financed mortgages of those borrowers who had the histories of default. Based on the concept of high risk-high reward, banks and financial institutions devised products which catered the needs of subprime borrowers which ultimately resulted into the crisis as subprime borrowers started to default on their payments.

The problem emerged when, through financial innovation, banks and financial institutions securitized those mortgages and issued fixed income securities whose payments were tied with the repayments received from subprime mortgage repayments. The process of securitization thus created essentially the mismatch between cash flows which finally culminated into the crises. This research paper will attempt to analyse and understand how and why crisis emerged, where the crisis emerged and the possible role of hedge funds into crises besides discussing its impact on world financial markets in general and Australian Financial Markets specially.

"Sub-Prime lendSubprime lending"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). Sub prime lending is relatively a new and a popular especially for mortgage loans like interest loans. These types of loans are typically targeted to first time buyers of homes or borrowers with restricted capacity to finance new home purchase. Most of the homeowners tend to use this class of borrowing in order to consolidate their debts or when their credit ratings fall to a level where they can be declared as bankrupts mainly due to the fact that their available funds are utilized in some other resourcess such as high medical bills etc.

(Blanton, 2005). Subprime lending became famous for many reasons. On one hand it not catered the needs of low quality customers but also provided an opportunity to the financial institutions to charge high amount of interest rates and other fees therefore banks, spotting the opportunity to earn high started to lend extensively in this area. Due to this perceived high reward, financial institutions take the risk because it is compensated through better returns.Subprime lending- a problemMost of the subprime lending has been made in mortgage markets.

It was because of this reason that homeownership increased tremendously over the period of time besides being favorite of the persons with loose credit ratings and a history of defaults. With the advent of financial innovation which took place especially after 1970s saw the emergence of financial derivatives as one of the most important financial instruments for banks to use in different situations. Banks, in order to regain the lost liquidity used in subprime lending started to securitize their mortgage portfolios by issuing mortgaged backed securities. However,