There has been a HUGE issue affecting the whole economy. That problem is, of cou

Question

There has been a HUGE issue affecting the whole economy. That problem is, of course, the fall out from the sub-prime mortgage mess. What is it? What segments of the economy have been affected? Why has the Treasury and FRB had to step in and pour TRILLIONS of dollars into the economy?? How does Risk Management enter into a discussion of investments in subprime mortgages? How have the financial institutions we've studied this semester handled their exposure to risk from these investments and what has happened to many of these financial institutions??

What is going on in the lending area? Are banks and other FI's taking on more risk by increasing their lending? How has this affected the economy? This directly affects the Risk Management topics of the last two modules.

Explanation / Answer

A financial crisis that arose in the mortgage market after a sharp increase in mortgage foreclosures, mainly subprime, collapsed numerous mortgage lenders and hedge funds.

The meltdown spilled over into the global credit market as risk premiums increased rapidly and capital liquidity was reduced. The sharp increase in foreclosures and the problems in the subprime mortgage market were largely blamed on loose lending practices, low interest rates, a housing bubble and excessive risk taking by lenders and investors.

It is also known as the "subprime collapse" or "subprime crisis".

Following the tech bubble and the events of September 11, the Federal Reserve stimulated a struggling economy by cutting interest rates to historically low levels. As a result, a housing bull market was created. People with poor credit got in on the action when mortgage lenders created non-traditional mortgages: interest-only loans, payment-option ARMs and mortgages with extended amortization periods. Eventually, interest rates climbed back up and many subprime borrowers defaulted when their mortgages were reset to much higher monthly payments. This left mortgage lenders with property that was worth less than the loan value due to a weakening housing market. Defaults increased; the problem snowballed, and several lenders went bankrupt.

Investors and hedge funds also suffered because lenders sold mortgages they originated into the secondary market. Here the mortgages were bundled together and sold to investors as collateralized debt obligations (CDOs) and other mortgage-backed securities (MBSs). When the higher risk underlying mortgages started to default, investors were left with properties that were quickly losing value. In the wake of the meltdown, central banks released liquidity into the market place, which allowed struggling lenders and hedge funds to continue operations and make the necessary payments on their obligations.

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