Subprime mortgage crisis

Over the last several years property values have gone up in the United States. Interest rates were also very low. This encouraged people to borrow at low rates and purchase properties. This drove prices further upwards. The buyers believed that the climate of rising prices would continue forever and they could refinance at more favourable terms and/or make a profit by selling it.

The banks lent money to borrowers with lower income and/or lesser credit history. The rising prices seemed indestructible. There is a form of financial engineering called securitization. Through this vehicle mortgage lenders passed on the rights to the mortgage payments and the related default risk to third party investors. This was offered through mortgage backed securities.

When the housing bubble burst and the prices no longer increased, refinancing by buyers became more difficult. Interest payable on adjustable rate mortgages was reset higher. Defaults and foreclosure activities increased dramatically. In 2007, more than a million housing properties in the US were subject to foreclosure activity. The lenders who retained the credit risk were the first to be affected as certain borrowers became unable or unwilling to make the payments. The unwilling issue comes up when the property values become lower than the borrowing.

The widespread defaults and credit risk caused lenders to reduce their lending or provide loans at higher rates. This affected the ability of corporations to borrow through commercial paper. Banks had to write off subprime loans – Citigroup the largest bank reported writing off $10B in the last quarter and $5.1B in quarter ending March 08. All this caused a liquidity crisis in many countries.

The Government and Federal Reserve have tried to ease the liquidity crisis through reduction of interest rates and bail out for certain financial institutions. This also impacted USD. The USD became weaker relative to other currencies. This drives prices upwards. In a related development commodity prices have been spiralling upwards. All this lead to erosion of investor confidence. The rate cut on interest rates and the economic stimulus package signed by the President are designed to improve liquidity and stimulate economic growth and inspire investor confidence in the financial markets