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Subprime mortgage crisis

The subprime mortgage crisis is an ongoing real estate crisis and financial crisis triggered by a
dramatic rise in mortgage delinquencies and foreclosures in the United States, with major adverse
consequences for banks and financial markets around the globe. The crisis, which has its roots in the
closing years of the 20th century, became apparent in 2007 and has exposed pervasive weaknesses
in financial industry regulation and the global financial system.
Approximately 80% of U.S. mortgages issued in recent years to subprime borrowers were adjustable-
rate mortgages. After U.S. house prices peaked in mid-2006 and began their steep decline thereafter,
refinancing became more difficult. As adjustable-rate mortgages began to reset at higher rates,
mortgage delinquencies soared. Securities backed with subprime mortgages, widely held by financial
firms, lost most of their value. The result has been a large decline in the capital of many banks and
U.S. government sponsored enterprises, tightening credit around the world.

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ontents
1c 1 Background and timeline of events
1c 1.1 Mortgage market
2c 2 auses
1c 2.1 Boom and bust in the housing market
2c 2.2 Speculation
3c 2.3 High-risk mortgage loans and lending/borrowing practices
4c 2.4 Securitization practices
5c 2.5 Inaccurate credit ratings
6c 2.6 Government policies
7c 2.7 Policies of central banks
8c 2.8 Financial institution debt levels and incentives
9c 2.9 redit default swaps
10c 2.10 US Balance of Payments
11c 2.11 Boom and collapse of the shadow banking system
3c 3 Impacts
1c 3.1 Impact in the U.S.
2c 3.2 Financial market impacts, 2007
3c 3.3 Financial market impacts, 2008
4c 4 Responses
1c 4.1 Federal Reserve and central banks
2c 4.2 Economic stimulus
3c 4.3 Bank solvency and capital replenishment
4c 4.4 Bailouts and failures of financial firms
5c 4.5 Homeowner assistance
1c 4.5.1 Homeowners Affordability and Stability Plan
5c 5 Regulatory proposals and long-term solutions
1c 5.1 Other responses
6c 6 Implication

c 6.1 Implications in India

Background and timeline of events

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Factors contributing to housing bubble

Domino effect as housing prices declined

The immediate cause or trigger of the crisis was the bursting of the United States housing bubble
which peaked in approximately 2005±2006. High default rates on "subprime" and adjustable rate
mortgages (ARM), began to increase quickly thereafter. However, once interest rates began to rise
and 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. Falling prices
also resulted in homes worth less than the mortgage loan, providing a financial incentive for borrowers
to enter foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the U.S. continues
to be a key factor in the global economic crisis, because it drains wealth from consumers and erodes
the financial strength of banking institutions.
In the years leading up to the crisis, significant amounts of foreign money flowed into the U.S. from
fast-growing economies in Asia and oil-producing countries. This inflow of funds combined with low
U.S. interest rates from 2002-2004 contributed to easy credit conditions, which fueled both housing
and credit bubbles. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain
and consumers assumed an unprecedented debt load.As part of the housing and credit booms, the
amount of financial agreements called mortgage-backed securities (MBS), which derive their value
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from mortgage payments and housing prices, greatly increased. Such financial innovation enabled
institutions and investors around the world to invest in the U.S. housing market. As housing prices
declined, major global financial institutions that had borrowed and invested heavily in subprime MBS
reported significant losses. Total losses are estimated in the trillions of U.S. dollars globally.
The risks to the broader economy created by the housing market downturn and subsequent financial
market crisis were primary factors in several decisions by central banks around the world to cut
interest rates and governments to implement economic stimulus packages. Effects on global stock
markets due to the crisis have been dramatic. Between 1 January and 11 October 2008, owners of
stocks in U.S. corporations had suffered about $8 trillion in losses, as their holdings declined in value
from $20 trillion to $12 trillion. Losses in other countries have averaged about 40%. Losses in the
stock markets and housing value declines place further downward pressure on consumer spending, a
key economic engine. Leaders of the larger developed and emerging nations met in November 2008
and March 2009 to formulate strategies for addressing the crisis.As of April 2009, many of the root
causes of the crisis had yet to be addressed. A variety of solutions have been proposed by
government officials, central bankers, economists, and business executives.
Mortgage market

Number of U.S. residential properties subject to foreclosure actions by quarter (2007-2009).

Subprime borrowers typically have weakened credit histories and reduced repayment capacity.
Subprime loans have a higher risk of default than loans to prime borrowers. If a borrower is delinquent
in making timely mortgage payments to the loan servicer (a bank or other financial firm), the lender
may take possession of the property, in a process called foreclosure.
The value of USA subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5
million first-lien subprime mortgages outstanding.Between 2004-2006 the share of subprime
mortgages relative to total originations ranged from 18% -21%, versus less than 10% in 2001-2003
and during 2007. In the third quarter of 2007, subprime ARMs making up only 6.8% of USA
mortgages outstanding also accounted for 43% of the foreclosures which began during that quarter.
By October 2007, approximately 16% of subprime adjustable rate mortgages (ARM) were either 90-
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days delinquent or the lender had begun foreclosure proceedings, roughly triple the rate of 2005. By
January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%.
The value of all outstanding residential mortgages, owed by USA households to purchase residences
housing at most four families, was US$9.9 trillion as of year-end 2006, and US$10.6 trillion as of
midyear 2008. During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million
properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81% increase vs.
2007,and again to 2.8 million in 2009, a 21% increase vs. 2008.
By August 2008, 9.2% of all U.S. mortgages outstanding were either delinquent or in foreclosure. By
September 2009, this had risen to 14.4%.Between August 2007 and October 2008, 936,439 USA
residences completed foreclosure. Foreclosures are concentrated in particular states both in terms of
the number and rate of foreclosure filings. Ten states accounted for 74% of the foreclosure filings
during 2008; the top two (alifornia and Florida) represented 41%. Nine states were above the
national foreclosure rate average of 1.84% of households.

auses
The crisis can be attributed to a number of factors pervasive in both housing and credit markets,
factors which emerged over a number of years. auses proposed include the inability of homeowners
to make their mortgage payments, due primarily to adjustable-rate mortgages resetting, borrowers
overextending, predatory lending, speculation and overbuilding during the boom period, risky
mortgage products, high personal and corporate debt levels, financial products that distributed and
perhaps concealed the risk of mortgage default, monetary policy, international trade imbalances, and
government regulation (or the lack thereof). Three important catalysts of the subprime crisis were the
influx of moneys from the private sector, the banks entering into the mortgage bond market and the
predatory lending practices of mortgage brokers, specifically the adjustable-rate mortgage, 2-28 loan.
On Wall Street and in the financial industry, moral hazard lay at the core of many of the causes.
During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade,
market participants sought higher yields without an adequate appreciation of the risks and failed to exercise
proper due diligence. At the same time, weak underwriting standards, unsound risk management practices,
increasingly complex and opaque financial products, and consequent excessive leverage combined to create
vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not
adequately appreciate and address the risks building up in financial markets, keep pace with financial
innovation, or take into account the systemic ramifications of domestic regulatory actions.

Speculation

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Speculative borrowing in residential real estate has been cited as a contributing factor to the subprime
mortgage crisis. During 2006, 22% of homes purchased (1.65 million units) were for investment
purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005,
these figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes
purchases were not intended as primary residences. David Lereah, NAR's chief economist at the
time, stated that the 2006 decline in investment buying was expected: "Speculators left the market in
2006, which caused investment sales to fall much faster than the primary market."
Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the historical
appreciation at roughly the rate of inflation. While homes had not traditionally been treated as
investments subject to speculation, this behavior changed during the ho using boom. Media widely
reported condominiums being purchased while under construction, then being "flipped" (sold) for a
profit without the seller ever having lived in them. Some mortgage companies identified risks inherent
in this activity as early as 2005, after identifying investors assuming highly leveraged positions in
multiple properties.
Nicole Gelinas of the Manhattan Institute described the negative consequences of not adjusting tax
and mortgage policies to the shifting treatment of a home from conservative inflation hedge to
speculative investment. Economist Robert Shiller argued that speculative bubbles are fueled by
"contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising.
Bubbles are primarily social phenomena; until we understand and address the psychology that fuels
them, they're going to keep forming."Keynesian economist Hyman Minsky described how speculative
borrowing contributed to rising debt and an eventual collapse of asset values.

High-risk mortgage loans and lending/borrowing practices

In the years before the crisis, the behavior of lenders changed dramatically. Lenders offered more and
more loans to higher-risk borrowers, including illegal immigrants. Subprime mortgages amounted to
$35 billion (5% of total originations) in 1994, 9% in 1996, $160 billion (13%) in 1999, and $600 billion
(20%) in 2006. A study by the Federal Reserve found that the average difference between subprime
and prime mortgage interest rates (the "subprime markup") declined significantly between 2001 and
2007. The combination of declining risk premia and credit standards is common to boom and bust
credit cycles.
In addition to considering higher-risk borrowers, lenders have offered increasingly risky loan options
and borrowing incentives. In 2005, the median down payment for first-time home buyers was 2%, with
43% of those buyers making no down payment whatsoever. By comparison, hina has down
payment requirements that exceed 20%, with higher amounts for non -primary residences.

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Growth in mortgage loan fraud based upon US Department of the Treasury Suspicious Activity Report Analysis.
The mortgage qualification guidelines began to change. At first, the stated income, verified assets
(SIVA) loans came out. Proof of income was no longer needed. Borrowers just needed to "state" it
and show that they had money in the bank. Then, the no income, verified assets (NIVA) loans came
out. The lender no longer required proof of employment. Borrowers just needed to show proof of
money in their bank accounts. The qualification guidelines kept getting looser in order to produce
more mortgages and more securities. This led to the creation of NINA. NINA is an abbreviation of No
Income No Assets (sometimes referred to as Ninja loans). Basically, NINA loans are official loan
products and let you borrow money without having to prove or even state any owned assets. All that
was required for a mortgage was a credit score.
Another example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to
pay just the interest (not principal) during an initial period. Still another is a "paym ent option" loan, in
which the homeowner can pay a variable amount, but any interest not paid is added to the principal.
An estimated one-third of ARMs originated between 2004 and 2006 had "teaser" rates below 4%,
which then increased significantly after some initial period, as much as doubling the monthly payment.
The proportion of subprime ARM loans made to people with credit scores high enough to qualify for
conventional mortgages with better terms increased from 41% in 2000 to 61% by 2006. However,
there are many factors other than credit score that affect lending. In addition, mortgage brokers in
some cases received incentives from lenders to offer subprime ARM's even to those with credit
ratings that merited a conforming (i.e., non -subprime) loan.
Mortgage underwriting standards declined precipitously during the boom period. The use of
automated loan approvals allowed loans to be made without appropriate review and documentation.In
2007, 40% of all subprime loans resulted from automated underwriting. The chairman of the Mortgage
Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not
do enough to examine whether borrowers could repay. Mortgage fraud by lenders and borrowers
increased enormously. In 2004, the Federal Bureau of Investigation warned of an "epidemic" in
mortgage fraud, an important credit risk of nonprime mortgage lending, which, they said, could lead to
"a problem that could have as much impact as the S&L crisis". However, continued strong demand for
MBS and DO began to drive down lending standards, as long as mortgages could still be sold along
the supply chain. Eventually, this speculative bubble proved unsustainable. NPR described it this way:
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The problem was that even though housing prices were going through the roof, people weren't making any
more money. From 2000 to 2007, the median household income stayed flat. And so the more prices rose, the
more tenuous the whole thing became. No matter how lax lending standards got, no matter how many exotic
mortgage products were created to shoehorn people into homes they couldn't possibly afford, no matter what
the mortgage machine tried, the people just couldn't swing it. By late 2006, the average home cost nearly four
times what the average family made. Historically it was between two and three times. And mortgage lenders
noticed something that they'd almost never seen before. People would close on a house, sign all the mortgage
papers, and then default on their very first payment. No loss of a job, no medical emergency, they were
underwater before they even started. And although no one could really hear it, that was probably the moment
when one of the biggest speculative bubbles in American history popped.
Securitization practices

Borrowing under a securitization structure.

Securitization and Mortgage-backed security
The traditional mortgage model involved a bank originating a loan to the borrower/homeowner and
retaining the credit (default) risk. With the advent of securitization, the traditional model has given way
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to the "originate to distribute" model, in which banks essentially sell the mortgages and distribute
credit risk to investors through mortgage-backed securities. Securitization meant that those issuing
mortgages were no longer required to hold them to maturity. By selling the mortga ges to investors, the
originating banks replenished their funds, enabling them to issue more loans and generating
transaction fees. This created a moral hazard in which an increased focus on processing mortgage
transactions was incentivized but ensuring their credit quality was not.
Securitization accelerated in the mid-1990s. The total amount of mortgage-backed securities issued
almost tripled between 1996 and 2007, to $7.3 trillion. The securitize d share of subprime mortgages
(i.e., those passed to third-party investors via MBS) increased from 54% in 2001, to 75% in 2006.
American homeowners, consumers, and corporations owed roughly $25 trillion during 2008. American
banks retained about $8 trillio n of that total directly as traditional mortgage loans. Bondholders and
other traditional lenders provided another $7 trillion. The remaining $10 trillion came from the
securitization markets. The securitization markets started to close down in the spring of 2007 and
nearly shut-down in the fall of 2008. More than a third of the private credit markets thus became
unavailable as a source of funds. In February 2009, Ben Bernanke stated that securitization markets
remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie
Mae and Freddie Mac.
A more direct connection between securitization and the subprime crisis relates to a fundamental fault
in the way that underwriters, rating agencies and investors modeled the correlation of risks among
loans in securitization pools. orrelation modeling²determining how the default risk of one loan in a
pool is statistically related to the default risk for other loans ²was based on a "Gaussian copula"
technique developed by statistician David X. Li. This technique, widely adopted as a means of
evaluating the risk associated with securitization transactions, used what turned out to be an overly
simplistic approach to correlation. Unfortunately, the flaws in this technique did not become apparent
to market participants until after many hundreds of billions of dollars of ABS and DOs backed by
subprime loans had been rated and sold. By the time investors stopped buying subprime-backed
securities²which halted the ability of mortgage originators to extend subprime loans ²the effects of
the crisis were already beginning to emerge.
Inaccurate credit ratings
redit rating agencies and the subprime crisis

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MBS credit rating downgrades, by quarter.

redit rating agencies are now under scrutiny for having given investment-grade ratings to MBSs
based on risky subprime mortgage loans. These high ratings enabled these MBS to be sold to
investors, thereby financing the housing boom. These ratings were believed justified because of risk
reducing practices, such as credit default insurance and equity investors willing to bear the first
losses. However, there are also indications that some involved in rating subprime-related securities
knew at the time that the rating process was faulty.
ritics allege that the rating agencies suffered from conflicts of interest, as they were paid by
investment banks and other firms that organize and sell structured securities to investors.On 11 June
2008, the SE proposed rules designed to mitigate perceived conflicts of interest between rating
agencies and issuers of structured securities.On 3 December 2008, the SE approved measures to
strengthen oversight of credit rating agencies, following a ten -month investigation that found
"significant weaknesses in ratings practices," including conflicts of interest.
Between Q3 2007 and Q2 2008, rating agencies lowered the credit ratings on $1.9 trillion in mortgage
backed securities. Financial institutions felt they had to lower the value of their MBS and acquire
additional capital so as to maintain capital ratios. If this involved the sale of new shares of stock, the
value of the existing shares was reduced. Thus ratings downgrades lowered the stock prices of many
financial firms.

Government policies
Government policies and the subprime mortgage crisis

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U.S. Subprime lending expanded dramatically 2004-2006

Both government failed regulation and deregulation contributed to the crisis. In testimony before
ongress both the Securities and Exchange ommission (SE) and Alan Greenspan conceded
failure in allowing the self-regulation of investment banks.
Increasing home ownership has been the goal of several presidents including Roosevelt, Reagan,
linton and G.W.Bush. In 1982, ongress passed the Alternative Mortgage Transactions Parity Act
(AMTPA), which allowed non-federally chartered housing creditors to write adjustable -rate mortgages.
Among the new mortgage loan types created and gaining in popularity in the early 1980s were
adjustable-rate, option adjustable-rate, balloon-payment and interest-only mortgages. These new loan
types are credited with replacing the long standing practice of banks making conventional fixed-rate,
amortizing mortgages. Among the criticisms of banking industry deregulation that contributed to the
savings and loan crisis was that ongress failed to enact regulations that would have prevented
exploitations by these loan types. Subsequent widespread abuses of predatory lending occurred with
the use of adjustable-rate mortgages.Approximately 80% of subprime mortgages are adjustable-rate
mortgages.
In 1995, the GSEs like Fannie Mae began receiving government tax incentives for purchasing
mortgage backed securities which included loans to low income borrowers. Thus began the
involvement of the Fannie Mae and Freddie Mac with the subprime market.In 1996, HUD set a goal
for Fannie Mae and Freddie Mac that at least 42% of the mortgages they purchase be issued to
borrowers whose household income was below the median in their area. This target was increased to
50% in 2000 and 52% in 2005. From 2002 to 2006, as the U.S. subprime market grew 292% over
previous years, Fannie Mae and Freddie Mac combined purchases of subprime securities rose from
$38 billion to around $175 billion per year before dropping to $90 billion per year, which included $350
billion of Alt-A securities. Fannie Mae had stopped buying Alt-A products in the early 1990s because
of the high risk of default. By 2008, the Fannie Mae and Freddie Mac owne d, either directly or through
mortgage pools they sponsored, $5.1 trillion in residential mortgages, about half the total U.S.
mortgage market.The GSE have always been highly leveraged, their net worth as of 30 June 2008
being a mere US$114 billion. When concerns arose in September 2008 regarding the ability of the
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GSE to make good on their guarantees, the Federal government was forced to place the companies
into a conservatorship, effectively nationalizing them at the taxpayers' expense.
The Glass-Steagall Act was enacted after the Great Depression. It separated commercial banks and
investment banks, in part to avoid potential conflicts of interest between the lending activities of the
former and rating activities of the latter. Economist Joseph Stiglitz criticized the repeal of the Act. He
called its repeal the "culmination of a $300 million lobbying effort by the banking and financial services
industries...spearheaded in ongress by Senator Phil Gramm." He believes it contributed to this crisis
because the risk-taking culture of investment banking dominated the more conservative commercial
banking culture, leading to increased levels of risk -taking and leverage during the boom period. The
Federal government bailout of thrifts during the savings and loan crisis of the late 1980s may have
encouraged other lenders to make risky loans, and thus given rise to moral hazard.[
onservatives and Libertarians have also debated the possible effects of the ommunity
Reinvestment Act (RA), with detractors claiming that the Act encouraged lending to uncreditworthy
borrowers,and defenders claiming a thirty year history of lending without i ncreased risk. Detractors
also claim that amendments to the RA in the mid -1990s, raised the amount of mortgages issued to
otherwise unqualified low-income borrowers, and allowed the securitization of RA-regulated
mortgages, even though a fair number of them were subprime.
Both Federal Reserve Governor Randall Kroszner and FDI hairman Sheila Bair have stated their
belief that the RA was not to blame for the crisis.

Economist Paul Krugman argued in January 2010 that the simultaneous growth of the residential and
commercial real estate pricing bubbles undermines the case made by those who argue that Fannie
Mae, Freddie Mac, RA or predatory lending were primary causes of the crisis. In other words,
bubbles in both markets developed even though only the residential market was affected by these
potential causes.

Policies of central banks

Federal Funds Rate and Various Mortgage Rates

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entral banks manage monetary policy and may target the rate of inflation. They have some authority
over commercial banks and possibly other financial institutions. They are less concerned with
avoiding asset price bubbles, such as the housing bubble and dot-com bubble. entral banks have
generally chosen to react after such bubbles burst so as to minimize collateral damage to the
economy, rather than trying to prevent or stop the bubble itself. This is because identifying an asset
bubble and determining the proper monetary policy to deflate it are matters of debate among
economists.
Some market observers have been concerned that Federal Reserve actions could give rise to moral
hazard. A Government Accountability Office critic said that the Federal Reserve Bank of New York's
rescue of Long-Term apital Management in 1998 would encourage large financial institutions to
believe that the Federal Reserve would intervene on their behalf if risky loans went so ur because they
were ³too big to fail.´
A contributing factor to the rise in house prices was the Federal Reserve's lowering of interest rates
early in the decade. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target
from 6.5% to 1.0%. This was done to soften the effects of the collapse of the dot-com bubble and of
the September 2001 terrorist attacks, and to combat the perceived risk of deflation. The Fed believed
that interest rates could be lowered safely primarily because the rate of inflation was low; it
disregarded other important factors. Richard W. Fisher, President and EO of the Federal Reserve
Bank of Dallas, said that the Fed's interest rate policy during the early 2000s was misguided, because
measured inflation in those years was below true inflation, which led to a monetary policy that
contributed to the housing bubble. According to Ben Bernanke, now chairman of the Federal Reserve,
it was capital or savings pushing into the United States, due to a world wide "saving glut", which kept
long term interest rates low independently of entral Bank action.
The Fed then raised the Fed funds rate significantly between July 2004 and July 2006. This
contributed to an increase in 1-year and 5-year ARM rates, making ARM interest rate resets more
expensive for homeowners. This may have also contributed to the deflating of the housing bubble, as
asset prices generally move inversely to interest rates and it became riskier to speculate in housing.

Financial institution debt levels and incentives

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Leverage Ratios of Investment Banks Increased Significantly 2003±2007

Many financial institutions, investment banks in particular, issued large amounts of debt during 2004 ±
2007, and invested the proceeds in mortgage-backed securities (MBS), essentially betting that house
prices would continue to rise, and that households would continue to make their mortgage payments.
Borrowing at a lower interest rate and investing the proceeds at a higher interest rate is a form of
financial leverage. This is analogous to an individual taking out a second mortgage on his residence
to invest in the stock market. This strategy proved profitable during the housing boom, but resulted in
large losses when house prices began to decline and mortgages began to default. Beginning in 2007,
financial institutions and individual investors holding MBS also suffered significant losses from
mortgage payment defaults and the resulting decline in the value of MBS.
A 2004 U.S. Securities and Exchange ommission (SE) decision related to the net capital rule
allowed USA investment banks to issue substantially more debt, which was then used to purchase
MBS. Over 2004-07, the top five US investment banks each significantly increased their financial
leverage (see diagram), which increased their vulnerability to the declining value of MBSs. These five
institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for
2007. Further, the percentage of subprime mortgages originated to total originations increased from
below 10% in 2001-2003 to between 18-20% from 2004±2006, due in-part to financing from
investment banks.
During 2008, three of the largest U.S. investment banks either went bankrupt (Lehman Brothers) or
were sold at fire sale prices to other banks (Bear Stearns and Merrill Lynch). These failures
augmented the instability in the global financial system. The remaining two investment banks, Morgan
Stanley and Goldman Sachs, opted to become commercial banks, thereby subjecting themselves to
more stringent regulation.
In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2
trillion in assets and liabilities off-balance sheet into special purpose vehicles or other entities in the
shadow banking system. This enabled them to essentially bypass existing regulations regarding
minimum capital ratios, thereby increasing leverage and profits during the boom but increasing losses
during the crisis. New accounting guidance will require them to put some of these assets back onto
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their books during 2009, which will significantly reduce their capital ratios. One news agency
estimated this amount to be between $500 billion and $1 trillion. This effect was considered as part of
the stress tests performed by the government during 2009.
Martin Wolf wrote in June 2009: "...an enormous part of what banks did in the early part of this decade
± the off-balance-sheet vehicles, the derivatives and the 'shadow banking system' itself ± was to find a
way round regulation."
The New York State omptroller's Office has said that in 2006, Wall Street executives took home
bonuses totaling $23.9 billion. "Wall Street traders were thinking of the bonus at the end of the year,
not the long-term health of their firm. The whole system²from mortgage brokers to Wall Street risk
managers²seemed tilted toward taking short-term risks while ignoring long-term obligations. The
most damning evidence is that most of the people at the top of the banks didn't really understand how
those [investments] worked."
Investment banker incentive compensation was focused on fees generated from assembling financial
products, rather than the performance of those products and profits generated over time. Their
bonuses were heavily skewed towards cash rather than stock and not subject to "claw-back"
(recovery of the bonus from the employee by the firm) in the event the MBS or DO created did not
perform. In addition, the increased risk (in the form of financial leverage) taken by the major
investment banks was not adequately factored into the compensation of senior executives.

redit default swaps

redit default swaps (DS) are financial instruments used as a hedge and protection for debtholders,
in particular MBS investors, from the risk of default. As the net worth of banks and other financial
institutions deteriorated because of losses related to subprime mortgages, the likelihood increased
that those providing the insurance would have to pay their counterparties. This created uncertainty
across the system, as investors wondered which companies would be required to pay to cover
mortgage defaults.
Like all swaps and other financial derivatives, DS may either be used to hedge risks (specifically, to
insure creditors against default) or to profit from speculation. The volume of DS outstanding
increased 100-fold from 1998 to 2008, with estimates of the debt covered by DS contracts, as o f
November 2008, ranging from US$33 to $47 trillion. DS are lightly regulated. As of 2008, there was
no central clearing house to honor DS in the event a party to a DS proved unable to perform his
obligations under the DS contract. Required disclosure of DS -related obligations has been
criticized as inadequate. Insurance companies such as American International Group (AIG), MBIA,
and Ambac faced ratings downgrades because widespread mortgage defaults increased their
potential exposure to DS losses. These firms had to obtain additional funds (capital) to offset this

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exposure. AIG's having DSs insuring $440 billion of MBS resulted in its seeking and obtaining a
Federal government bailout.
Like all swaps and other pure wagers, what one party loses under a DS, the other party gains; DSs
merely reallocate existing wealth [that is, provided that the paying party can perform]. Hence the
question is which side of the DS will have to pay and will it be ab le to do so. When investment bank
Lehman Brothers went bankrupt in September 2008, there was much uncertainty as to which financial
firms would be required to honor the DS contracts on its $600 billion of bonds outstanding. Merrill
Lynch's large losses in 2008 were attributed in part to the drop in value of its unhedged portfolio of
collateralized debt obligations (DOs) after AIG ceased offering DS on Merrill's DOs. The loss of
confidence of trading partners in Merrill Lynch's solvency and its ability to refin ance its short-term debt
led to its acquisition by the Bank of America.
Economist Joseph Stiglitz summarized how credit default swaps contributed to the systemic
meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the
financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets
froze."

US Balance of Payments

U.S. urrent Account or Trade Deficit

In 2005, Ben Bernanke addressed the implications of the USA's high and rising current account
deficit, resulting from USA investment exceeding its savings, or imports exceeding exports. Between
1996 and 2004, the USA current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP.
The US attracted a great deal of foreign investment, mainly from the emerging economies in Asia and
oil-exporting nations. The balance of payments identity requires that a country (such as the USA)
running a current account deficit also have a capital account (investment) surplus of the same
amount. Foreign investors had these funds to lend, either because they had very high personal
savings rates (as high as 40% in hina), or because of high oil prices. Bernanke referred to this as a
"saving glut" that may have pushed capital into the USA, a view differing from that of some other
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economists, who view such capital as having been pulled into the USA by its high consumption levels.
In other words, a nation cannot consume more than its income unless it sells assets to foreigners, or
foreigners are willing to lend to it.
Regardless of the push or pull view, a "flood" of funds (capital or liquidity) reached the USA financial
markets. Foreign governments supplied funds by purchasing USA Treasury bonds and thus avoided
much of the direct impact of the crisis. USA households, on the other hand, used funds borrowed from
foreigners to finance consumption or to bid up the prices of housing and financial assets. Financial
institutions invested foreign funds in mortgage-backed securities. USA housing and financial assets
dramatically declined in value after the housing bubble burst.

Boom and collapse of the shadow banking system

In a June 2008 speech, President of the NY Federal Reserve Bank Timothy Geithner, who later
became Secretary of the Treasury, placed significant blame for the freezing of credit markets on a
"run" on the entities in the "parallel" banking system, also called the shadow banking system. These
entities became critical to the credit markets underpinning the financial system, but were not subject
to the same regulatory controls as depository banks. Further, these entities were vulnerable because
they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant
that disruptions in credit markets would make them subject to rapid deleveraging, selling their long -
term assets at depressed prices. He described the significance of these entities: "In early 2007, asset-
backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred
securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly
$2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds
grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks
totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United
States at that point were just over $6 trillion, and total assets of the entire banking system were about
$10 trillion." He stated that the "combined effect of these factors was a financ ial system vulnerable to
self-reinforcing asset price and credit cycles."
Nobel laureate Paul Krugman described the run on the shadow banking system as the "core of what
happened" to cause the crisis. "As the shadow banking system expanded to rival or even surpass
conventional banking in importance, politicians and government officials should have realized that
they were re-creating the kind of financial vulnerability that made the Great Depression possible²and
they should have responded by extending regulations and the financial safety net to cover these new
institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank
does, anything that has to be rescued in crises the way banks are, should be regulated like a bank."
He referred to this lack of controls as "malign neglect."

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The securitization markets supported by the shadow banking system started to close down in the
spring of 2007 and nearly shut-down in the fall of 2008. More than a third of the private credit markets
thus became unavailable as a source of funds.

Impacts
Financial crisis of 2007±2010
Impact in the U.S.

Impacts from the risis on Key Wealth Measures

Between June 2007 and November 2008, Americans lost more than a quarter of their net worth. By
early November 2008, a broad U.S. stock index, the S&P 500, was down 45 percent from its 2007
high. Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30 -35%
potential drop. Total home equity in the United States, which was valued at $13 trillion at its peak in
2006, had dropped to $8.8 trillion by mid -2008 and was still falling in late 2008. Total retirement
assets, Americans' second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006
to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from
retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses
total a staggering $8.3 trillion. Members of USA minority groups received a disproportionate number of
subprime mortgages, and so have experienced a disproportionate level of the resulting foreclosures.

Financial market impacts, 2007

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FDI Graph - U.S. Bank & Thrift Profitability By Quarter

The crisis began to affect the fin ancial sector in February 2007, when HSB, the world's largest
(2008) bank, wrote down its holdings of subprime-related MBS by $10.5 billion, the first major
subprime related loss to be reported. During 2007, at least 100 mortgage companies either shut
down, suspended operations or were sold. Top management has not escaped unscathed, as the
EOs of Merrill Lynch and itigroup resigned within a week of each other in late 2007. As the crisis
deepened, more and more financial firms either merged, or announced that they were negotiating
seeking merger partners.
During 2007, the crisis caused panic in financial markets and encouraged investors to take their
money out of risky mortgage bonds and shaky equities and put it into commodities as "stores of
value". Financial speculation in commodity futures following the collapse of the financial derivatives
markets has contributed to the world food price crisis and oil price increases due to a "commodities
super-cycle." Financial speculators seeking quick returns have removed trillions of dollars from
equities and mortgage bonds, some of which has been invested into food and raw materials.
Mortgage defaults and provisions for future defaults caused profits at the 8533 USA depository
institutions insured by the FDI to decline from $35.2 billion in 2006 Q4 billion to $646 million in the
same quarter a year later, a decline of 98%. 2007 Q4 saw the worst bank and thrift quarterly
performance since 1990. In all of 2007, ins ured depository institutions earned approximately $100
billion, down 31% from a record profit of $145 billion in 2006. Profits declined from $35.6 billion in
2007 Q1 to $19.3 billion in 2008 Q1, a decline of 46%.

Financial market impacts, 2008

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Indirect economic effects of the subprime mortgage crisis

As of August 2008, financial firms around the globe have written down their holdings of subprime
related securities by US$501 billion. The IMF estimates that financial institutions around the globe will
eventually have to write off $1.5 trillion of th eir holdings of subprime MBSs. About $750 billion in such
losses had been recognized as of November 2008. These losses have wiped out much of the capital
of the world banking system. Banks headquartered in nations that have signed the Basel Accords
must have so many cents of capital for every dollar of credit extended to consumers and businesses.
Thus the massive reduction in bank capital just described has reduced the credit available to
businesses and households.
When Lehman Brothers and other important financial institutions failed in September 2008, the crisis
hit a key point. During a two day period in September 2008, $150 billion were withdrawn from USA
money funds. The average two day outflow had been $5 billion. In effect, the money market was
subject to a bank run. The money market had been a key source of credit for banks (Ds) and
nonfinancial firms (commercial paper). The TED spread (see graph above), a measure of the risk of
interbank lending, quadrupled shortly after the Lehman failure. This credit freeze brought the global
financial system to the brink of collapse. The response of the USA Federal Reserve, the European
entral Bank, and other central banks was immediate and dramatic. During the last quarter of 2008,
these central banks purchased US$2.5 trillion of government debt and troubled private assets from
banks. This was the largest liquidity injection into the credit market, and the largest monetary policy
action, in world history. The governments of European nations and the USA also raised the capital of
their national banking systems by $1.5 trillion, by purchasing newly issu ed preferred stock in their
major banks.
However, some economists state that Third-World economies, such as the Brazilian and hinese
ones, will not suffer as much as those from more developed countries.
The International Monetary Fund estimated that large U.S. and European banks lost more than $1
trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are
expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1 trillion and

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European bank losses will reach $1.6 trillion. The IMF estimated that U.S. banks were about 60
percent through their losses, but British and eurozone banks only 40 percent.

Responses
Subprime mortgage crisis solutions

Various actions have been taken since the crisis became apparent in August 2007. In September
2008, major instability in world financial markets increased awareness and attention to the crisis.
Various agencies and regulators, as well as political officials, began to take additional, more
comprehensive steps to handle the crisis.
To date, various government agencies have committed or spent trillions of dollars in loans, asset
purchases, guarantees, and direct spending. For a summary of U.S. government financial
commitments and investments related to the crisis, see NN - Bailout Scorecard.

‡cFederal Reserve and central banks

Federal Reserve responses to the subprime crisis
The central bank of the USA, the Federal Reserve, in partnership with central banks around the world,
has taken several steps to address the crisis. Federal Reserve hairman Ben Bernanke stated in
early 2008: "Broadly, the Federal Reserve's response has followed two tracks: efforts to support
market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary
policy." The Fed has:
Ŷc Lowered the target for the Federal funds rate from 5.25% to 2%, and the discount rate from
5.75% to 2.25%. This took place in six steps occurring between 18 September 2007 and 30
April 2008; In December 2008, the Fed further lowered the federal funds rate target to a range
of 0-0.25% (25 basis points).
Ŷc Undertaken, along with other central banks, open market operations to ensure member banks
remain liquid. These are effectively short-term loans to member banks collateralized by
government securities. entral banks have also lowered the interest rates (called the discount
rate in the USA) they charge member banks for short-term loans;
Ŷc reated a variety of lending facilities to enable the Fed to lend directly to banks and non -bank
institutions, against specific types of collateral of varying credit quality. These include the Term
Auction Facility (TAF) and Term Asset-Backed Securities Loan Facility (TALF).
Ŷc In November 2008, the Fed announced a $600 billion program to purchase the MBS of the
GSE, to help lower mortgage rates.

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Ŷc In March 2009, the FOM decided to increase the size of the Federal Reserve¶s balance
sheet further by purchasing up to an additional $750 billion of agency (GSE) mortgage-backed
securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to
increase its purchases of agency debt this year by up to $100 billion to a total of up to $200
billion.
‡cEconomic stimulus
Economic Stimulus Act of 2008
American Recovery and Reinvestment Act of 2009
On 13 February 2008, President Bush signed into law a $168 billion economic stimulus package,
mainly taking the form of income tax rebate checks mailed directly to taxpayers. hecks were mailed
starting the week of 28 April 2008. However, this rebate coincided with an unexpected jump in
gasoline and food prices. This coincidence led some to wonder whether the stimulus package would
have the intended effect, or whether consumers would simply spend their rebates to cover higher food
and fuel prices.
On 17 February 2009, U.S. President Barack Obama signed the American Recovery and
Reinvestment Act of 2009, an $787 billion stimulus package with a broad spectrum of spending and
tax cuts. Over $75 billion of which was specifically allocated to programs which help struggling
homeowners. This program is referred to as the Homeowner Affordability and Stability Plan.

‡cBank solvency and capital replenishment

Emergency Economic Stabilization Act of 2008

ommon Equity to Total Assets Ratios for Major USA Banks

Losses on mortgage-backed securities and other assets purchased with borrowed money have
dramatically reduced the capital base of financial institutions, rendering many either insolvent or less
capable of lending. Governments have provided funds to banks. Some banks have taken significant
steps to acquire additional capital from private sources.
The U.S. government passed the Emergency Economic Stabilization Act of 2008 (EESA or TARP)
during October 2008. This law included $700 billion in funding for the " Troubled Assets Relief
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Program" (TARP), which was used to lend funds to banks in exchange for dividend-paying preferred
stock.
Another method of recapitalizing banks is for government and private investors to provide cash in
exchange for mortgage-related assets (i.e., "toxic" or "legacy" assets), improving the quality of bank
capital while reducing uncertainty regarding the financial position of banks. U.S. Treasury Secretary
Timothy Geithner announced a plan during March 2009 to purchase "legacy" or "toxic" assets from
banks. The Public-Private Partnership Investment Program involves government loans and
guarantees to encourage private investors to provide funds to purchase toxic assets from banks.

‡cBailouts and failures of financial firms

List of bankrupt or acquired banks during the financial crisis of 2007±2008, Federal takeover of
Fannie Mae and Freddie Mac, Government intervention during the subprime mortgage
crisis, and Bailout

People queuing outside a Northern Rock bank branch in Birmingham, United Kingdom on September 15, 2007, to
withdraw their savings because of the subprime crisis.
Several major financial institutions either failed, were bailed-out by governments, or merged
(voluntarily or otherwise) during the crisis. While the specific circumstances varied, in general the
decline in the value of mortgage-backed securities held by these companies resulted in either their
insolvency, the equivalent of bank runs as investors pulled funds from them, or inability to secure new
funding in the credit markets. These firms had typically borrowed and invested large sums of money
relative to their cash or equity capital, meaning they were highly leveraged and vulnerable to
unanticipated credit market disruptions.
The five largest U.S. investment banks, with combined liabilities or debts of $4 trillion, either went
bankrupt (Lehman Brothers), were taken over by other companies (Bear Stearns and Merrill Lynch),
or were bailed-out by the U.S. government (Goldman Sachs and Morgan Stanley) during 2008.
Government-sponsored enterprises (GSE) Fannie Mae and Freddie Mac either directly owed or
guaranteed nearly $5 trillion in mortgage obligations, with a similarly weak capital base, when they
were placed into receivership in September 2008. For scale, this $9 trillion in obligations concentrated
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in seven highly leveraged institutions can be compared to the $14 trillion size of the U.S. economy
(GDP) or to the total national debt of $10 trillion in September 2008.

‡cHomeowner assistance

‡c Homeowners Affordability and Stability Plan

Regulatory proposals and long-term solutions

Subprime mortgage crisis solutions debate and Regulatory responses to the subprime crisis
President Barack Obama and key advisers introduced a series of regulatory proposals in June 2009.
The proposals address consumer protection, executive pay, bank financial cushions or capital
requirements, expanded regulation of the shadow banking system and derivatives, and enhanced
authority for the Federal Reserve to safely wind-down systemically important institutions, among
others.
A variety of regulatory changes have been proposed by economists, politicians, journalists, and
business leaders to minimize the impact of the current crisis and prevent recurrence. However, as of
June 2009, many of the proposed solutions have not yet been implemented. These include:
Ŷc Ben Bernanke: Establish resolution procedures for closing troubled financial institutions in the
shadow banking system, such as investment banks and hedge funds.
Ŷc Joseph Stiglitz: Restrict the leverage that financial institutions can assume. Require executive
compensation to be more related to long-term performance. Re-instate the separation of
commercial (depository) and investment banking established by the Glass-Steagall Act in
1933 and repealed in 1999 by the Gramm-Leach-Bliley Act.
Ŷc Simon Johnson: Break-up institutions that are "too big to fail" to limit systemic risk.
Ŷc Paul Krugman: Regulate institutions that "act like banks " similarly to banks.
Ŷc Alan Greenspan: Banks should have a stronger capital cushion, with graduated regulatory
capital requirements (i.e., capital ratios that increase with bank size), to "discourage them from
becoming too big and to offset their competitive advantage."
Ŷc Warren Buffett: Require minimum down payments for home mortgages of at least 10% and
income verification.
Ŷc Eric Dinallo: Ensure any financial institution has the necessary capital to support its financial
commitments. Regulate credit derivatives and ensure they are traded on well-capitalized
exchanges to limit counterparty risk.
Ŷc Raghuram Rajan: Require financial institutions to maintain sufficient "contingent capital" (i.e.,
pay insurance premiums to the government during boom periods, in exchange for payments
during a downturn.)
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Ŷc A. Michael Spence and Gordon Brown: Establish an early-warning system to help detect
systemic risk.
Ŷc Niall Ferguson and Jeffrey Sachs: Impose haircuts on bondholders and counterparties prior to
using taxpayer money in bailouts.
Ŷc Nouriel Roubini: Nationalize insolvent banks. Reduce debt levels across the financial system
through debt for equity swaps. Reduce mortgage balances to assist homeowners, giving the
lender a share in any future home appreciation.
Ŷc Paul Mculley advocated "counter-cyclical regulatory policy to help modulate human nature."
He cited the work of economist Hyman Minsky, who believed that human behavior is pro-
cyclical, meaning it amplifies the extent of booms and busts. In other words, humans are
momentum investors rather than value investors. ounter-cyclical policies would include
increasing capital requirements during boom periods and reducing them during busts. [235]
U.S. Treasury Secretary Timothy Geithner testified before ongress on October 29, 2009. His
testimony included five elements he stated as critical to effective reform: 1) Expand the FDI bank
resolution mechanism to include non-bank financial institutions; 2) Ensure that a firm is allowed to fail
in an orderly way and not be "rescued"; 3) Ensure taxpayers are not on the hook for any losses, by
applying losses to the firm's investors and creating a monetary pool funded by the largest financial
institutions; 4) Apply appropriate checks and balances to the FDI and Federal Reserve in this
resolution process; 5) Require stronger capital and liquidity positions for financial firms and related
regulatory authority.
Other responses
Significant law enforcement action and litigation is resulting from the crisis. The U.S. Federal Bureau
of Investigation was looking into the possibility of fraud by mortgage financing companies Fannie Mae
and Freddie Mac, Lehman Brothers, and insurer American International Group, among others. New
York Attorney General Andrew uomo is suing Long Island based Amerimod, one of the nation's
largest loan modification corporations for fraud, and has issued 14 subpoenas to other similar
companies. The FBI also assigned more agents to mortgage-related crimes and its caseload has
dramatically increased. The FBI began a probe of ountrywide in March 2008 for possible fraudulent
lending practices and securities fraud.
Over 250 civil lawsuits were filed in federal courts during 2007 related to the subprime crisis. The
number of filings in state courts was not quantified but is also believed to be significant.

Implications
Estimates of impact have continued to climb. During April 2008, International Monetary Fund (IMF)
estimated that global losses for financial institutions would approach $1 trillion.One year later, the IMF
estimated cumulative losses of banks and other financial institutions globally would exceed $4 trillion.
This is equal to U.S. $20,000 for each of 200,000,000 people.
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Francis Fukuyama has argued that the crisis represents the end of Reaganism in the financial sector,
which was characterized by lighter regulation, pared-back government, and lower taxes. Significant
financial sector regulatory changes are expected as a result of the crisis.
Fareed Zakaria believes that the crisis may force Americans and their government to live within their
means. Further, some of the best minds may be redeployed from financial engineering to more
valuable business activities, or to science and technology.
Roger Altman wrote that "the crash of 2008 has inflicted profound damage on [the U.S.] financial
system, its economy, and its standing in the world; the crisis is an important geopolitical setback...the
crisis has coincided with historical forces that were already shifting the world's focus away from the
United States. Over the medium term, the United States will have to operate from a smaller global
platform -- while others, especially hina, will have a chance to rise faster."
GE EO Jeffrey Immelt has argued that U.S. trade deficits and budget deficits are unsustainable.
America must regain its competitiveness through innovative products, training of production workers,
and business leadership. He advocates specific national goals related to energy security or
independence, specific technologies, expansion of the manufacturing job base, and net exporter
status."The world has been reset. Now we must lead an aggressive American renewal to win in the
future." Of critical importance, he said, is the need to focus on technology and manufacturing. ³Many
bought into the idea that America could go from a technology -based, export-oriented powerhouse to a
services-led, consumption-based economy ² and somehow still expect to prosper,´ Jeff said. ³That
idea was flat wrong.´
Economist Paul Krugman wrote in 2009: "The prosperity of a few years ago, such as it was ² profits
were terrific, wages not so much ² depended on a huge bubble in housing, which replaced an earlier
huge bubble in stocks. And since the housing bubble isn¶t coming back, the spending that sustained
the economy in the pre-crisis years isn¶t coming back either." Niall Ferguson stated that excluding the
effect of home equity extraction, the U.S. economy grew at a 1% rate during the Bush years. [250]
Microsoft EO Steve Ballmer has argued that this is an economic reset at a lower level, rather than a
recession, meaning that no quick recovery to pre-recession levels can be expected.
The U.S. Federal government's efforts to support the global financial system have resulted in
significant new financial commitments, totaling $7 trillion by November, 2008. These commitments
can be characterized as investments, loans, and loan guarantees, rather than direct expenditures. In
many cases, the government purchased financial assets such as commercial paper, mortgage-
backed securities, or other types of asset-backed paper, to enhance liquidity in frozen markets. As the
crisis has progressed, the Fed has expanded the collateral against which it is willing to lend to include
higher-risk assets.
The Economist wrote: "Having spent a fortune bailing out their banks, Western governments will have
to pay a price in terms of higher taxes to meet the interest on that debt. In the case of countries (like
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Britain and America) that have trade as well as budget deficits, those higher taxes will be needed to
meet the claims of foreign creditors. Given the political implications of such austerity, the temptation
will be to default by stealth, by letting their currencies depreciate. Investors are increasingly alive to
this danger..."
The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely
liquidated, and home price deflation comes to an end. That will stabilize the now-uncertain value of the home
equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for
residential mortgage-backed securities. Very large losses will, no doubt, be taken as a consequence of the
crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally,
will be able to get back to business.

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How often have we used the word ͚sub prime͛ in the last one and a half years? Well, the
Americans seem to have caught a fancy for the word. They love the word so much that it has been
voted to be the word of the year 2007 by the American Dialect Society. This euphoria and interest
in the word is justified to a great extent. After all, it is the cause of the many worries of the
Americans and probably the entire world.
Sub prime, as the word suggests, is any thing that is not pr ime. In the sub prime crisis context it
simply means lending money to sub prime borrowers i.e. lending to people with low or poor credit
worthiness. Much thought and energy has already been spent in the literature in understanding
the causes of the sub prime crisis. To put it very simply the sub prime crisis was caused because
the lending norms in the USA were very lax. It is joked about in the academic circles that any man
who was not on a respirator was given a loan with out any regard to his or her credi tworthiness.
This was brought about by the ͞Spend yourself out of the post dot com bust recession͟ policy of
the American government at that time.
The end result of the sub prime crisis is manifesting itself in myriad ways. There are direct and
indirect implications not only for the United States but for the entire world. Let us briefly the
effects of this crisis on the Indian economy.
1. Firstly, the sub prime crisis has led to near loss of confidence in the American Stock Markets,
and this has accentuated the credit crunch. Many big investment banks have been brought down
to their knees and many others are finding it extremely difficult to stay on their feet. In order to
consolidate their respective balance sheets in the United States, these banks are unwi nding
positions in developing markets hence causing down swing in these markets. A simple case in
point was the intra day 1400 points fall on the BSE in January 2008 that was brought about by Citi
Bank unwinding its position in manyfront line stocks in Ind ia. The sub prime that was brought
upon by the American financial system upon itself is spreading its tentacles around the world.
People who were not even remotely connected with the sub prime crisis are being adversely
affected.

2. Secondly, the near recession situation in the USA has led to a loss of demand for Indian exports
hence loss of export earnings for India. The Americans are known to live beyond their means.
However, on account of the sub prime crisis, all their sources of credit have dried up, and they are
being forced to cut down on their expenditures. Thus demand for imports is falling, which implies
loss of revenues for countries like India. Not only is there a loss in the goods sector, but the IT
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sector is also feeling the pinch. Software de velopment for many US firms takes place in India but
as the American firms are facing an economic slowdown, they are demanding less IT products,
leading to a fall in the growth rate of the Indian IT sector.

3. Thirdly, investment banks and other financial institutions are on a job slashing spree to cut
costs. This means that many jobs in India are at stake because these institutions have their BPO͛s
in India. So the first jobs to go will be the low end Indian BPO jobs leading to increased
unemployment in India.
4. Fourthly, there will be serious implications for the banking sector as well. The sub prime has
meant that the Indian banks have to follow stricter norms while disbursing loans to the people.
These tighter norms could prove to be counter cyclical. The argument is this- people will be asked
to provide collateral for the loans given to them. Anybody who is unable to furnish the collateral
will be denied a loan. This policy will exclude a majority of the population from institutional
sources of credit, thereby affecting growth negatively.
5. Fifthly, there is a risk of the financial contagion spreading to the entire world. Firms like Bear
Sterns, Lehman Brothers, Meryl Lynch who once inspired confidence amongst the
investor class have now gone bust. Oth er giants like Citi Bank, Morgan Stanley, and AIG have been
shaken from their very foundations. Freddie Mac and Fannie Mae are under the conservatorship
of the US government. The risk is, thus, the domino effect. If one more big financial institution fails
there will be a collapse of the entire financial system of the USA.
CONCLUSION
In retrospect we can conclude that due to increased financial integration of the world, risks
emanating in one country are being transmitted to other nations. There is no doubt that the
financial system of the entire world is under great strain. The first of the dominos by the name of
Lehman Brothers has fallen. The policy makers are trying all that they can to stem the fall of any
more dominos. Only time will tell whether they succeed in their endeavour. Time is running out
and the policymakers can not afford to fail. c