Akanksha Gupta(Sec B) PGDM Reg No: M073-14

Akanksha Gupta(SEC-B) Reg No: M073-14

SUBPRIME MORTGAGE CRISIS

Sub-prime Mortgage crisis started in early 2000's when excess capital was available with the investors to invest
at low interest rates. The demand was for low risk investments which gave nice returns. At the same time the
housing sector of the US economy offered lucrative returns. Mortgage backed securities-in this case the loan
given to the seeker keeping his/her house as collateral, had good credit rating i.e. AAA by the credit ratings
agency as Fitch, Moody's, S&P's. The reason for the good credit rating given by the credit rating agencies was
the wrong data being used to calculate rating. Therefore, they arrived at the faulty rating. The investors with
ample capital invested in the mortgage backed securities. The whole process worked in the following manner-
An individual got mortgage loan from broker. Broker sold the mortgage to banks. Banks in turn sold it to Wall
Street and Wall Street to investment firm. Investment Firm in turn sold the shares of mortgage loans to
investors. The process of selling of mortgage loans can be represented by the following arrow diagram:
Individual -> Broker -> Banks -> Wall Street -> Investment Firm -> Investors
Mortgage loans were considered to be safe bet by the investors as they offered regular payments. However,
the same mortgage loan process was extended to buyers having poor credit rating. Hence, the term Sub-Prime
crisis. Offered interest rates were as low as 1-2%. Their ability to repay the loan was not taken into account.
Buyers purchased houses with mortgage loans. With greater number of buyers wanting to invest in houses,
the price of houses went up. It increased the return in prices. This attracted more investors who wanted to
buy house as an investment only to sell it at greater price. Increased demand further pushed up housing price-
thereby creating a housing bubble. The people could then can easily get loan from bank against their house as
its worth increased.
During 2006-07 the US government increased the interest rate to 5-6% affecting the repayment capacity of
sub-prime investors. Since the funding to the housing market was done entirely by mortgage loans, increase in
interest rates undermined the ability of buyers to pay back the loan.
The buyers started defaulting and housing prices stopped increasing as a domino effect. With the number of
buyers decreasing and greater number of houses, the houses prices started going down and hence the housing
bubble burst.
US was witnessing the effect of bubble burst till recently in terms of higher unemployment rate(9-12%).
However, now it has gone down to 4%. The interest rate level was retained at low level. US GDP slowed down.
The immediate effect was the bankruptcy of Lehman Brothers, Merrill Lynch, Bear Stearns. Citigroup ran into
deep trouble. Federal Reserve adopted quantitative easing policy to counter the effect housing bubble burst
on US economy.
US economy is showing signs of recovery. Improved unemployment rate, lowering the buying amount for
quantitative easing policy and positive outlook of Fed substantiate the statement.





Akanksha Gupta(Sec B) PGDM Reg No: M073-14
Akanksha Gupta(SEC-B) Reg No: M073-14