The United States domestic subprime mortgage crisis did not occur overnight, nor can it be cured overnight. It had been building up for several years. The bubble finally burst in September 2008 and sent devastating waves throughout the world’s financial markets.

To appreciate the size of the crisis it is important first to take a quick look at the numbers. The U.S. mortgage market is estimated at $12 trillion of which over nine percent are currently delinquent or in foreclosure. Subprime loans represent only 6.8 percent of mortgage loans yet currently they represent 43 percent of foreclosures; in 2007 1.3 million properties were subject to foreclosure filings, an increase of 79% from the previous year.

There were several reasons for the crisis. First, banks and mortgage lenders, challenged by ever-increasing domestic competition, made too many high-risk home loans to borrowers with either poor credit or whose income did not justify the monthly mortgage payments and to those who were unable to make a meaningful down payment. Rising home values and poor lending practices over several years had encouraged homeowners to refinance, more often than not by way of adjustable rate mortgages. Additionally, overbuilding during the boom years created too much supply exacerbating a decline in real estate market values.

Interest rates began to rise in 2006 and this further contributed to a decline in home values in many parts of the United States making refinancing more difficult. This triggered an increase in defaults and foreclosures. The situation accelerated considerably and far faster than anyone anticipated and led to the global financial crisis of 2008.

How did this essentially domestic United States

subprime mortgage problem turn into a global financial crisis?

Traditionally banks provided finance to their customers to buy homes and took as security a mortgage on the properties. The banks retained the credit risk until the customer finally paid off his mortgage. This practice changed as a result of clever and intricate financial innovations whereby lenders sold to third parties the rights to receive the mortgage payments and at the same time off-loaded the accompanying credit risk. This process is termed”securitization.” These securities are called “mortgage backed securities” or “collateralized debt obligations.”

These mortgage backed securities were then packaged in multi-million dollar ‘lots’ and sold to, or underwritten by, the investment banking community which then sold them to investors throughout the world. As more and more homeowners defaulted, the amount of cash that flowed back into the mortgage backed securities pool dried up. This resulted in international financial mayhem.

At the present time the international community and the world’s central banks are working feverishly to come up with an acceptable band-aid. Without a quick fix, there will be more bank failures and a shut down in lending. This credit crunch will stifle the world’s economies in all sectors, manufacturing, wholesale, retail and distribution. No sector will escape the ripple effect.

But a quick-fix is not a solution to avert another mortgage crisis. Steps to be taken to limit the risk of a reoccurrence of the present crisis include, but are not limited to, improving the transparency of the financial instruments involved in securitization. The instruments that currently evidence mortgage backed securities are complex even to the most sophisticated investors. Greater transparency would allow for more efficient monitoring; Sensible and practical regulations by federal regulators; credit rating agencies to make their reports more informative and demonstrate greater clarity; Commercial banks to provide more information about their off-balance sheet activities; The trading of mortgage backed securities, or other derivatives, to take place only on regulated exchanges; a standardization of documentation and instruments; The world’s central banks insisting that commercial banks operating under their auspices should have more capital and less leverage and Greater effective government supervision.

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