A Deep Understanding of US Subprime Mortgage.docx
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ADeepUnderstandingofUSSubprimeMortgage
BirminghamBusinessSchool
MsCInternationalBusiness2010–2011
ModuleTitle:
IssueinManagement
BannerCode:
0722125
AssignmentNo:
1
Lecturer:
DrJohnChild
AssignmentTitle:
ADeepUnderstandingofU.S.SubprimeMortgage
WordCount:
2741
(Penaltieswillbeappliedtothosewhoexceedthestatedwordlimit)
IDnumber1115674
NOTyourname(allworkismarkedanonymously)
AdeepunderstandingofU.S.subprimemortgage
Introduction
Inthisessay,itwillpresentthemaincausesofAmericansubprimemortgagefinancialcrisis.Thisiscrisisischaracterizedbyadramaticriseinsubprimemortgagedelinquencies,whatisfollowingisthebankruptcyofsomefinancialinstitutions.Therearealargenumberofessaysthatelaboratethedirectandindirectcausesofthisfinancialcrisis.Whereasdifferentarticlesmayconcentratedifferentlyoncertaincauses.Thisessaywillmainlyfocusonthefollowingaspects.ThefirstreasonisthecollapseofthebubbleofU.S.realestatemarket.Asitisknowntoallthatthehousingbubbleplayedavitalroleinthiscrisis.Second,thelargeamountofsubprimemortgage.Numeroussubprimeborrowersgetinterest-onlyloansfrombanksandotherfinancialinstitutions.Andtheseloanswerebundledtoreselltootherinvestors,creatingalongfinancialchain.Astheseborrowerscouldnotaffordthemonthlypayment,thenallthefinancialchainbegantocollapse.Whatismore,thesefinancialinstitutionsarelackofresponsibilitiesforthemarket.Theypursuehighprofitsandneglectsomecrucialcrisis.Also,theinternationaltradeimbalancealsocontributedtothefinancialcrisis.Exportingpowers,likeChina,JapanandSaudiArabia,havingabigtradesurplus.SomeofthelargeofaccumulationofU.S.dollarsareinvestedinAmericangovernmentsecuritiesandotherfinancialinstitutionsthatarerelatedtorealestatemarket.Atlast,theeconomicpoliciesofU.S.FederalReservealsocontributedtothecrisis.Afewyearsbeforethecrisis,theFederalReservekeptthefederalfundsrateatalowlevel,whichmadeiteasyforthosesubprimeborrowerstogetmoney.Butwhenitraisedthefederalfundsratesomehomeownerscannotpayfortheadjustable-ratemortgage.ThisessaywillexplainthesereasonsaboveonebyoneandpresenttheirlinkswiththeU.S.subprimemortgagecrisis.Also,itwouldalsoproposesomesuggestionsforpreventingasimilarcrisisoccurringinthefuture.
Thecollapseofhousingbubble
SinceInternetbubbleburstin2000,AmericanshopethegrowthofrealestatecouldsavetheAmericaneconomyfromrecession.Whathappenednextistheriseinpriceofhouse.Thehousingpricekeptonrisinguntil2006,reachingthepeak.Thereisstatisticsprovesthatbetween1997and2006,thepriceoftypicalAmericanhouseincreasedby124%.Thenationalmedianhousepricerangedfrom2.9to3.1timesmedianAmericanhouseholdincome.Thisratioroseto4.0in2004,and4.6in2006.(Clifford,2009)Duetothelowinterestratesandtherisinghouseprice,asubstantialnumberofsubprimeborrowersgetcouragetobuyhouseswithmoneyfrombanksorotherfinancialinstitutions,likeFannieMaeandFreddieMac.Someofthoseborrowersdonothaveagoodcredit,tolendthemmoneyisofhighrisk.Atthattime,everyonethoughtthehousepricewouldkeeponrising,eventheycannotaffordthemonthlypayment,thehousecouldberesoldagainwithahigherprice.Accordingtothismethod,thereisnearlynoriskforlendingthemmoney.Butallofthisisbasedontherisingpriceofhouse.Therisinghousepriceencouragealargenumberofwhoactuallycannotaffordthefuturepaymenttobuyhouse.Theprosperousrealestatemarketalsocontributedtotheprosperityofhouseagents.Allofthesemadethehousingbubblebecomemoreandmorebig.Butwhenthehousingbubblecollapsed,thenightmarebegan,housingpricewentdown.Thefinancialmarketfacemanyproblemsrelatedtocapitalchain,whichledtobankruptcyofmanyfirms.
Largeamountofsubprimemortgage
First,weshouldunderstandwhatsubprimemortgageis.Itmeanslendingmoneytopeoplewhomayhavesomedifficultiesingivingthemoneybackaccordingtotherepaymentschedule.(Bellod,2009)Mostsubprimeborrowersmayhavepoorcredithistories,andwereregardingashighriskborrowerswhencomparingwithcommonborrowers.Astheriskishigh,solenderswoulddemandmorepremium.SubprimemortgageisthesourceofU.S.financialcrisis.Itbecamequitepopularinthelate1990s,butatthattime,theamountofsubprimeisnotsolargecomparingwithitof2006.Thesefinancialinstitutionsandbanksplayedavitalroleinpromotinglageramountofsubprimemortgages.Andtheyreallybenefittedalotfromsubprimemortgage.Atthesametime,thesesubprimelendingwerebondedintosecurities.Then,foreignfinancialinstitutionandinvestorswouldbuythesesecurities.Asitisobviousthatmostoftherisksweretransmittedfrombankstothosesecuritiesbuyers.Thesebankswouldbeenthusiastictolendmoremoneytothesesubprimeborrowers.What’smore,inordertolendmoremoneyformorebenefit.Bankscreatedsomeservicesformoresubprimeborrowers.AdjustableRateMortgages(ARMs)isawidelyusedtoolforbankstolendmoremoney.Itallowstheseborrowerstorepayasmallamountofmoneyinthefirstfewyears.ForsomeARMs,borrowersonlyhavetopaytheinterestsandtheinterestsinlowerthancommoninterestrates.Butwhenthefirstyearspast,theyhavetopayalargeamountofmoneyeverymonthoryear.Mostofthemcannotaffordit.Butasthehousingpricekeptonrising,peoplebelievethattheycouldbuythehouseandsellthemwhentheywhentheyhavetopaythemortgage.Thisencouragesasubstantialnumberofpeopletoborrowmoneyfrombanksandbuyhouseswhichtheycannotafford.Whentheinterestrateroseandthehousingpricewentdown,manyofthemfacedseriousproblems.Theirreturnedmoneywerethesourceofmanysecurities,whichcouldcauseddisastersforthecapitalchainwhichtightlyrelatedtothecrisis.
Thosefinancialinstitutionsarelackofresponsibilityandriskyfinancialinnovativeproducts
TheBankruptcyofLehmanBrotherswasthesymbolofthebeginningofU.S.subprimemortgagecrisis.Thereisnodoubtthatthesefinancialinstitutionsofwallstreetcontributedalottothesubprimemortgagecrisis.Somecompaniesborrowedmoneytopeoplewhowerehopingtobuyhouseswithoutevaluatingtheircredithistory.Buttheyknewthattheseloanswereofhighrisk,thentheyinvitedothercompaniestocooperatewiththem,bondingtheseloansintosecurities.Butthesesecuritieswerestrangetomanyinvestors.BothinvestorsinandoutofAmericawereafraidofrisk,especiallyforthoseSovereignwealthfunds.Inordertomakethembelievethesesecuritieswereinlowrisk.Evaluatingcompanies,likeMoody`s,joinedthisgame.Theseevaluatingcompaniesevaluatedsomeofthesesecuritieswithhighmarks,makinginvestorsbuythemwithlesshesitation.Buttherewerestillnotenoughbuyersforthosesecurities,then,insurancecompaniesjoinedthisgametoo.Someofthosesecuritieswereguaranteedbythem.Allthosefinancialinstitutionsworkedtogethertoselltheseloanstoinvestorsandusedtheirmoneytomakemoreloansandsecurities.Becauseofwhattheydid,theU.S.housingmarketseemedtobefluorescent.ButwhattheywereactuallydoingwascontributingtothehousingbubblewhichwasthefoundationoftheU.S.subprimemortgagecrisis.
Theinternationaltradeimbalance
Inrecentyears,exportingpowerslikeChinaJapanandsomeArabiccountries,theyexportedlargenumberoftheirproductstoothercountries.Atthesametime,theamountofimportedproductsislesswhencomparingwiththeirexport.Thisiscalledtradeimbalance.Whenone’sexportexceedsimport,therewouldbetradesurplus.Thentheywouldaccumulatealotofforeignexchangereserves.AsU.S.dollarismaintoolininternationaltrade,mostoftheirforeignexchangereservesisU.S.dollars.Inordertoavoidlossofdepreciationofthedollar,thesecountriestendtoinvesttheirmoneytobuygovernmentbondsandcorporatebonds.ThesedollarswentintofinancialinstitutionslikeFannieMaeandFreddieMac.ThesetwocompaniesplayedveryimportantrolesinU.S.houseloanmarket.Theygotenoughmoneyindirectlyfromthoseexportingpowers.Themoremoneytheygotthemoretheycouldlenttothosesubprimeborrowers.Becausetheyhaveenoughmoney,theywouldlietolendthemtomorepeopleandhavemoreprofit.Theydidnotpaymuchattentiontopeople’scredithistory,makingitpossibleforthoseactuallycannotaffordahousetobuyalargehouse.Morepeopleboughthouses,makingthehousingpriceincreaserapidlyinthattime.Butwhenhousingpricewentdown,thesubprimemortgagebegan.
TheeconomicpoliciesofU.S.FederalReserveandsupervisionofauthorities
Before2004,theU.S.FederalReservekeptthebenchmarkinterestrateatalowlevel,1%.Itaimedtopromotetheconsumptionandeconomicgrowth.Duetothelowinterestrate,peoplewouldbeeagertoborrowmoneyforconsumption.Asthehousingpricewasincreasingeveryyearatthattime,peoplewereencouragedbyhouseagenciestoborrowmoneytoinvestorbuyhouse.Actually,asubstantialnumberofpeoplewithlowincomereallydidthis.somefinancialinstitutionsalsoborrowedmoneyfrombanktoinvestinproductsthatrelatedtohouseloans.Notonlycommonpeoplebutalsofinancialinstitutionsboughtmoneyfrombanks.Agreatdealofmoneyinfluxintohousingmarket,promotingthehousingbubble.Also,theresupervisionsystemofauthoritiesdidnotworkwellonthefin