Sunday, September 21, 2008

What causes the US financial crisis?

The current economic crisis stemmed from the sub-prime mortgage crisis, which is a crisis of contracted liquidity in the global credit market.

Sub prime lending extends to mortgage, car loans and credit cards. It is the giving out of loans which do not meet the Fannie Mae and Frankie Mac at higher expectation of risk and at a higher interest rate.

Fannie Mae is a name for the Federal National Mortgage Association while Freddie Mac is the Federal Home Loan Monetary Corporation; together they guarantee about US $12 trillion of the mortgage market.

Both enterprises are government-sponsored enterprises and are authorized to make loans and loan guarantees. They are leading participants in the US secondary mortgage markers which serve to provide liquidity to the primary mortgage market. Secondary mortgage markets, market for sale of securities/ bonds collaterized by values of mortgafe loans, group these loans together and sell them as securities called collaterised market obligations (CMOs) to ensure mortgage companies have enough funds to lend to home buyers.

Sub prime lending gains popularity in the earlier years due to the easy initial terms of such loans and some predatory targeting acts by loaners to borrowers who do not understand the terms and conditions or to borrowers of unsuitable credit scores.

The initial rise in housing prices encourage borrowers to borrow difficult mortgage loans because they believe they able to refinance at more favorite times.

Alas, housing prices slump in year 2006 to 2007 and refinancing among the borrowers become difficult, the US housing bubble has burst, and there were high defaults rates of financing and foreclosures.

Mortgage leaders which retain credit risk were the first hit as borrowers defaulted on their payments.

Mortgage institutions have also passed the rights to mortgage payments and related credit and default risk to 3rd party investors via mortgage-backed securities (MBS) and collateral debt obligations (CDOs).

Investors holding MBS, CDOs faced loss as values of underlying mortgage declined

Stock markets were also affected,

Credit crunch hence results: sudden reduction in the availability of loans and at higher costs (fewer and more expensive loans)

This lead to reduced business expenditure and consumer spending.

And slowly the problem aggravates to assume the proportion which shocks the world as major banks such as UBS, the Lehman Brothers and AIG founder!


And not to mention that Fannie Mae and Frankie Mac were bought over by the US government.

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