"If you can't predict the future, then you need a system that can handle breakdown" John M. Keynes
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"The birth of economics as a discipline is usually credited by Adam Smith, who published "The Wealth of Nations" in 1776. Over the next 160 years an extensive body of economic theory was developed, whose central message was: Trust the Market." _ Paul Krugman
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"One fear is that foreign investors will stop buying U.S. debt, just as Washington needs to borrow more. Such a turn could lead to a dollar collapse, causing spikes in long-term rates and inflation. The less the U.S. need to borrow from abroad, the less downward pressure on the dollar - and the greater the balance in the global economy." _ James C. Cooper
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.
Under a conservatorship, the common and preferred shares of Fannie and Freddie would be reduced to little or nothing, and any losses on mortgages they own or guarantee could be paid by taxpayers. Shareholders have already lost billions of dollars as the stocks have plunged more than 80 percent this year.
A conservatorship would operate much like a pre-packaged bankruptcy, similar to what smaller companies use to clean up their books and then emerge with stronger balance sheets. It would allow for uninterrupted operation of the companies, crucial players in the diminished mortgage market, where they are now responsible for nearly 70 percent of new loans.
Will America follow Japan into a decade of stagnation?
AS FALLING house prices and tightening credit squeeze America’s economy, some worry that the country may suffer a decade of stagnation, as Japan did after its bubble burst in the early 1990s. Japan’s property bubble was also fuelled by cheap money and financial liberalisation and—just as in America—most people assumed that property prices could not fall nationally. When they did, borrowers defaulted and banks cut their lending. The result was a decade with average growth of less than 1%.
A series of articles on the crisis gripping the world economy and global markets starts where it all began—with America’s deeply flawed system of housing finance
The absurdity of this situation was highlighted by the way the discount window works. The Fed does not just accept any old assets as collateral; it wants assets that are “safe”. As well as Treasury bonds, it is willing to accept paper issued by “government-sponsored enterprises” (GSEs). But the two most prominent GSEs are Fannie Mae and Freddie Mac. In theory, therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press.
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They were set up (see article) to provide liquidity for the housing market by buying mortgages from the banks. They repackaged these loans and used them as collateral for bonds called mortgage-backed securities; they guaranteed buyers of those securities against default.
Fannie Mae and Freddie Mac were created by Congress to help more Americans buy homes. Now their shaky condition threatens the entire housing market.
By Katie Benner, writer
Last Updated: July 14, 2008: 1:16 PM EDT
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NEW YORK (Fortune) — They own or guarantee $5 trillion worth of mortgages – nearly half of all the country’s outstanding home loan debt – and they’re crashing. But not everybody is convinced they should be.
Fannie Mae and Freddie Mac are struggling with an investor loss of confidence so great that, while they’re unlikely to go under, they could conceivably see their ability to function impaired. That would wreak yet more havoc on an already wrecked housing market – making loans tougher to come by and possibly pushing hundreds of billions of dollars in cost onto U.S. taxpayers…
