The Financial Crisis and its effects on the world economy Essay

The Financial Crisis and its effects on the world economy - Essay Example Subprime Lending Subprime involves the credit status of the borrowers of subprime loans and does not correspond to the interest rates of such loans. Any type of loans offered to the subprime borrowers which do not satisfy the prime guidelines of a loan are termed as subprime loans. It is a process of lending money to a group of borrowers who are classified as subprime borrowers and they do not qualify for obtaining loans at market interest rates because of the fact that their credit ratings are too low (Duhigg â€Å"Pressured to Take More Risk, Fannie Reached Tipping Point.†). However, the underwriting standards were relaxed by the mortgage lenders because during the phase of strong competition, the availability of the creditworthy borrowers was limited. So the mortgage became risky because they were allowed to less creditworthy borrowers. A crisis situation created in the subprime mortgage market of United States intensified during 2007 and led to global recession (Labaton â €Å"Agency’s ’04 Rule Let Banks Pile up New Debt†). Housing Bubble It has been noticed that from 1997-2006, the housing price in USA has increased by 124 percent. In 2006 the housing prices in USA was very high, which started declining considerably in the year of 2006 and continued in 2007 too. In 2008, the Case-Shiller home price index revealed that the highest drop in the housing prices was seen in 2008 (Schmuecker). This resulted in the subprime crisis due to the obligation created by the Alt-A collateralized debt, Hedge funds, credit, and other mortgages. It heavily affected the new construction, as about 1,283,000 American families sold off their houses, in comparison to 609,000 during 1990-1995. Mortgage finance is one of the most important components in the property debt market. In the year 2008 the US government did offer special loans of about $900 million to rescue the country from housing bubble, but the amount of loss was already far beyond this amou nt (Barker 3). Weak Underwriting Practices The failure of the mortgage underwriting principles was prevalent in USA, as stated by Tichard M. Bowen III, the chief underwriter of Citigroup. He himself stated that among 1600 mortgages by Citi, about 60 percent of the mortgage loans were defective in nature (Morgenson â€Å"Raters Ignored Proof of Unsafe Loans, Panel is told†). This means that the underwriters did not perform their duties based on the policies. Apart from this, the Financial Crisis Enquiry Commission also scrutinized about 900,000 mortgages that were issued from 2006-2007. They found that barely 54 percent of the mortgage loans met the required underwriting standards. Among them about 28 percent mortgage loans even did not met the minimum standards of borrowing (Olin). Collapse and Boom of the Banking System There are various evidences that the risky mortgages were financed by the banking systems. The superfluous pressure from the showed banking system also led t he financial institutions lower their underwriting standards and support the initiation of risky loans. The CEO of the Federal Reserve Bank directly blamed the parallel banking or shadowed banking system for freezing the credit market. During 2007, the securitization market which was supported by the parallel banking system started to collapse and shut down by 2008. In this situation, the private credit market was not available to