How have subprime crisis affected US economy?

Answer 1

Current (April 2008) instability in the U.S. and to some degree international financial markets is not limited to sub-prime mortgages, although rising interest rates resulting in foreclosure have brought the issue to the public's attention. The current financial market uncertainty can be traced to the increasing use by financial institutions of asset-backed securities, in particular asset-backed commercial paper. Asset-backed securities are a way that companies borrow money. They are similar to bonds, which are basically loans to companies (or countries) that can be bought and sold in a relatively liquid bond market. Bonds are backed by a company's credit; the company is obligated to repay the bonds, or else face consequences such as bankruptcy. Asset-backed commercial paper is a fundamentally different way to borrow money. What "asset-backed" means is that the "interest" income the bondholder receives is based on a stream of payments from the underlying asset. The most common type of asset we are hearing about right now is home mortgages. So basically what happens is that a bank or other financial institution (the involvement of "other financial institutions" is a significant contributor to the growth in this market) makes loans such as home mortgages, or in other cases car loans, credit card payments, etc. So instead of a bank receiving mortgage payments and using them to pay back loans, foreclosing if necessary, banks are more or less an intermediary. They make loans, and then re-sell them in the commercial paper market. What people who own these securities get is essentially a bundle of home mortgage obligations. When people are paying back their home mortgages, everything works well. However, when people stop paying their mortgages, the owners of the commercial securities see the value of their investments plummet. Since the package of securities is relatively concentrated and homogeneous (rather than diverse, like a bank that makes loans to business, homeowners, car loans, credit cards, etc.), the risk of these securities is substantially higher than an investment in a large corporate stock or bond, or even regular commercial paper backed by the credit of a particular institution. One of the problems has been that it has been difficult to assess the risk and value of asset-backed securities. Home mortgage loans are divided into murky "troches," and the value of your security relates to which "troche" may underly your particular security. There is also a substantial opportunity for abuse and misrepresentation. Most notably, in 2003-2004 a company sold asset-backed securities supposedly based on rental income from various properties in India. As it turned out, the only "property" the corporation had was a rented office in a building off a dusty, isolated road. Essentially, all people needed was a Post Office box, and people were rushing to lend them money. So these securities were risky. But risk itself is not a problem, as long as investors are properly compensated for the risk with higher interest rates, for example. However, investors substantially underestimated the risk involved in these securities; as a result, banks and financial institutions were borrowing at relatively low interest rates. In addition, since non-bank institutions do not have the same reserve requirements as banks, they were able to create money much more efficiently. The end result was a substantial increase in the overall money supply, which will be discussed later. Part of the issue is that multiple components of the financial markets were involved in this business. Banks held some of this commercial paper, as did some money market funds. Also, payment of these bonds was frequently insured. So loss of faith in asset-backed securities could topple not only banks, but also large insurance companies and re-insurers, the companies that insure the insurance companies. Everyone more or less panicked and became much less willing to buy asset-backed securities. As stated above, the availability of asset-backed securities considerably increased the overall money supply. Recent economic theories suggest that interest rates, not money supply, directly impact the economy. This financial crisis may prove them wrong. The asset-backed commercial paper market resulted in a substantial increase in the money supply while interest rates remained low. Inflation appeared to be low partly because of low energy costs (because Saddam Hussein was secretly selling massive amounts of oil above and beyond his OPEC quota). In addition, inflation was concentrated in the housing sector -- not surprising, since that's where the majority of asset-backed security money was available. Availability of money through bonds and bank lending is the oil that allows the engine of the financial markets to keep working. Basically, people finally figured out that the engine has been leaking oil (perhaps literally) for many years. The financial engine finally seized up. Not only are they worried about banks, but also insurance companies, etc. That's why the Fed has stepped in to re-lubricate the engine by increasing the money supply (which will only serve to increase inflation, but that's another story). JP Morgan Chase stepped in to save America, just as good old JP Morgan did around the turn of the century. This "crisis" bears striking resemblance to the savings and loan crisis of the 1980s. A significant contributor in both cases is deregulation. The savings and loan crisis was caused because of substantial changes in federal regulations governing loan policies for S&Ls. In that situation as well, investors significantly underestimated the risk of the underlying assets. The parallel to savings and loans is the non-bank mortgage brokerages and other financial institutions that got into the home mortgage business. For example, Ditech looks like it is in the home loan business, but is actually a unit of GMAC -- that's right, auto-maker GM's financing arm. This is another connection that spells trouble. The only reasonably profitable business of U.S. automakers has been financing -- they don't make money on cars, they make money on selling loans to people who buy cars. This makes the already-troubled U.S. automakers dependent on a supply of income that has suddenly dried up. GM has an overall negative capitalization (has lost more money than it has ever made). Combined with changes in the car market toward smaller, more efficient vehicles as opposed to the SUVs that are U.S. car companies' bread and butter, it does not look good if you are an employee or retiree of the U.S. auto industry. So those people stop buying stuff, and people they stopped buying stuff from stop buying stuff, and so on. And the economy shuts down, known politely as a "recession." If this description sounds hauntingly like the second half of the 1970s and the first half of the 1980s, yes, there is reason to be afraid. The above dynamics are reminiscent of that period. Add to that concern over an emerging Asian economic power (then Japan, now China), skyrocketing oil prices, Middle East terrorism (Iran hostage crisis, anyone?) and significant concerns about American foreign policy and our ability to sustain our military and other commitments, and the feeling of deja vu is overwhelming.

Answer 2

According to a recent study the number of Subprime Mortgage Defaulters have increased considerably, as a result of which there seems a direct effect on the Economy.