Study of Subprime Mortgage Crisis 2008 October 11, 2008

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Introduction

The subprime mortgage crisis is an ongoing economic problem which became more apparent during 2007 and 2008, and is characterized by contracted liquidity in the global credit markets and banking system. The downturn in the U.S. housing market, risky lending and borrowing practices, and excessive individual and corporate debt levels have caused multiple adverse effects on the world economy.

In order to understand this crisis, we have created a diagram shown below with a manner of simplifying the crisis process related mainly to mortgage issues ranging from simple mortgage lending to complex structured finance like securitization of asset-backed securities (ABS), mortgage-backed securities (MBS), and collateralized debt obligations (CDO).

To explain the subprime crisis in the simplest way, we’re using the equation: V(A) + V(E) > V(D) assuming that all the wealth of individuals as well as institutions is related exclusively to a mortgage and its derivatives. On the left side of the equation, the value is equal to what is possessed by these individuals and institutions. On the right side of the equation, the value of debt equals what is borrowed by these individuals and institutions. For individuals and institutions who want to maintain a wealthy condition, the value of what they own must be greater than what they owe.

Then when V(A) + V(E) < V(D), it means that the value of the asset is less than the value of the debt. Those involved parties defaulted, which created the crisis.

Our purpose in this case study is trying to answer some of the following questions with easy-to-understand words and methods:

• · How the crisis happened
• · Who are the players/ Whose responsibility
• · What led to this crisis
• · When it get started
• · Where the issues and solutions placed

Subprime mortgage market

The subprime mortgage crisis could be pictured in draft as vicious cycle:

• · The crisis began with the burst of the United States housing bubble and high default rates on subprime and adjustable rate mortgages (ARM), beginning in approximately 2005-2006, which lead to the unexpected dramatically climb of payment default and foreclosure; then drove the devaluation of mortgage-backed securities, collateralized debt obligations, and the like.

• · The devaluation of asset-back securities caused financial institutions losing capital due to writedowns of their assets; in turn, those financial institutions want to control the leverage ratio and put themselves in a sensitive condition.

• · To reduce a leverage ratio, those institutions went on to sell off their MBS, which led to the more devaluation of these assets, the worse of leverage ratio, the more emergent situation of lending cutting and capital raising, and so on.

Then when V(A) + V(E) < V(D) meaning value of asset less than value of debt, those involved parties fell into default, which exposed as the crisis.