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The U.S. Financial Crisis
Sara Hsu
October 3, 2008
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It all started with US mortgages…
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Families just wanted to
pursue the American
dream of home ownership…
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But now many families are in danger of
losing the homes they worked so hard for.
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
People are also losing money in their
401Ks, and may not be able to get a home
or car loan.

In this talk, we will answer the following
questions: How did this begin? What
exactly is going on, and where is it leading?
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What happened?
The crisis began in the subprime
mortgage area, hitting the U.S. and
triggering a global financial crisis in 2008.
■
■ ■
 The crisis began with the bursting of the
US housing bubble and high default rates
on "subprime" mortgages made to higherrisk borrowers with lower income or lesser
credit history.

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What is subprime?

The term subprime lending refers to the
practice of making loans to borrowers who
do not qualify for market interest rates.
Interest rates for these borrowers are
usually higher.
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“Credit Crunch”
 Banks
are all facing a
problem of having less
credit for lending money,
since so many people
cannot pay back the
mortgage loans, and
since other financial
institutions have failed.
Other banks now will not
lend to them. This is a
“credit crunch.”
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When did this begin?
The stock market & dot-com crash in 2000
resulted in many people taking their
money out of the stock market and
purchasing real estate, which many
believed to be a more reliable investment.
■ ■ ■
 At the same time, the Federal Reserve cut
short-term interest rates to historically low
levels, from about 6.5% to just 1%, which
allowed more people to purchase homes
for a lower cost.

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
Subprime borrowing was a major
contributor to an increase in
home ownership rates and the
demand for housing.

Some homeowners used
increased property values from
the housing bubble to refinance
their homes with lower interest
rates and take out second
mortgages against the added
value to use the funds for
consumer spending.
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
Then the bubble burst. Overbuilding during
the boom period, increasing foreclosure rates
and unwillingness of many homeowners to sell
their homes at reduced market prices have
significantly increased the supply of housing
inventory available, driving down prices.

More homeowners are now at risk of default
and foreclosure.
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Foreclosure has hit some Americans very hard.
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Borrowing Climate Changed
Borrowers took out loans under terms that
were not so great, since they thought they
would be able to refinance at more favorable
terms later.
■ ■ ■
 But once housing prices started to drop
moderately in 2006-2007, refinancing
became more difficult. Defaults and
foreclosure activity increased dramatically as
interest rates reset higher.

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
The mortgage lenders that
retained credit risk were the first
to be affected, as borrowers
became unable to make
payments.

Major banks and other financial
institutions around the world
reported major losses, with
Lehman Brothers recently
declaring bankruptcy and other
major lenders, including Fannie
and Freddie, seeking shelter.
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Securitization
Owing to securitization, many mortgage
lenders had passed the rights to the
mortgage payments and related credit &
default risk to third-party investors via
mortgage-backed securities (MBS) and
collateralized debt obligations (CDO).
■ ■ ■
 Corporate, individual and institutional
investors holding MBS or CDO faced
significant losses, as the value of the
underlying mortgage assets declined.

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Financial Institutions
A
variety of factors caused lenders to
offer an increasing array of higherrisk loans to higher-risk borrowers.
■ ■ ■
 The risk premium required by lenders
to offer a subprime loan declined.
This occurred even though subprime
borrower and loan characteristics
declined overall during the 20012006 period.
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Mortgage Brokers
Mortgage brokers do not lend their own
money. There is not a direct relationship
between actual loan performance and
income for mortgage brokerages.
■ ■ ■
 They have big financial incentives for
selling complex adjustable rate mortgages
(ARMs), since they earn higher
commissions.

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Mortgage Underwriters

Underwriters determine if the risk of
lending to a particular borrower meet their
criteria of credit, capacity and collateral,
but these were not closely looked at
leading up to the lending crisis.
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Credit Rating Agencies

Credit rating agencies
are now under scrutiny
for giving high ratings to
the securities based on
subprime mortgage
loans. Rating agencies
are paid by investment
banks, so they had a
financial incentive for
marking up the ratings.
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Central Banks

The US central bank, the Federal Reserve,
lowered interest rates just after the dotcom crash to counter the risk of deflation,
but this encouraged borrowers to take out
more home loans.
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Federal Reserve Response to Crisis
At first, the Fed lowered interest rates and
then sent a call out to banks to negotiate
mortgage terms with their borrowers, to
prevent foreclosures.
■ ■ ■
 When the crisis deepened, the Fed bailed
out Fannie Mae and Freddie Mac, let
Lehman Brothers go bankrupt, and
purchased equity in AIG. The Fed also
persuaded the President and Congress to
pass a $700 billion bailout for banks.

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The $700 Billion Bailout
Sets up a Troubled Assets Relief Fund to
purchase banks’ troubled assets at low price
 Raises FDIC to $250,000 to aid small
businesses
 Underlying mortgage holders’ rights remain
the same; encouraged to contact HOPE
 Subject to management/auditing oversight
 Renewal of R&D tax breaks for businesses
for spending on renewable energy

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Regulatory Responses

The Fed has promised to
tighten regulation of
financial institutions.
Goldman Sachs and
Merrill Lynch jumped the
gun by voluntarily
transforming themselves
into regular banks, which
face tighter regulations.
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Effect on Stock Markets

Stock markets have
been volatile as various
events of the crisis
have played out. Over
the past year, the Dow
Jones Industrial
Average has fallen by
over 3,000 points, over
20%.
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Effect on Stock Markets

Crisis has caused panic
in financial markets and
encouraged investors to
take their money out of
risky mortgage bonds
and shaky equities and
put it into commodities
like corn and oil as
"stores of value".
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Effect on Financial Institutions

Financial institutions
have suffered greatly,
with Lehman Brothers
going bankrupt and
Fannie Mae and Freddie
Mac being taken under
government control.
Other banks will
struggle to renew their
competitiveness.
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Effect on Home Owners
 Housing
prices are expected to
continue declining until the inventory of
surplus homes is reduced to more
typical levels.
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Effect on Businesses
The effect on businesses has yet to be seen,
since the “real” economy is next to be
affected by the financial crisis.
 Lower supplies of consumer credit mean
demand for goods and services will fall.
 We have seen unemployment increase in
September, and will likely increase more in
October, as workers from the financial and
then real sector are laid off, as demand falls.

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Transmission to Global Economies
International banks that
bought securities based on
US subprime mortgages
have been caught up in
the crisis.
 The crisis has also spread
as international financial
markets have become
volatile and vulnerable to
the credit crunch.
 The global economy faces
an enormous slowdown.

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Anger at American Financiers

At a summit meeting on the US financial
crisis, Brazilian President Luiz Inacio Lula
da Silva said “the euphoria of speculators
has spawned the anguish of entire
peoples, in the wake of successive
financial disasters that threaten the
world's economy. We must not allow the
burden of the boundless greed of a few to
be shouldered by all.''
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Transmission to Global Economies

Increase in world food
and commodity prices
has resulted from the
transfer of investment
from housing to
commodities such as
wheat and corn.
Prices of food are
much higher in every
country.
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Future Possibilities
How long it will take markets to
overcome the financial crisis and
portending recession has yet to be
seen. Effects on consumers and
businesses continue as credit becomes
less available.
 Those who wanted to retire now must
wait until later or cope with having less
in their 401K than they had planned.
 Current and future generations face a
prodigious tax burden.

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