The Subprime Mortgage Crisis

Abstract

The paper attempts to research on the steps or strategies’ adopted by the global community especially the leading economies to come up with a lasting solution to the global subprime crisis whose effects are adverse and dangerous to the economic growth of the entire continent. The fed, bank of England among other institutions have taken their actions to ensure their citizens and their economy’s recover from the crisis.

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However, the reactions of these institutions are still not clear on whether they will solve the problem completely or not. Therefore, the paper would like to review the strategies of various international financial institutions in providing solution to the subprime crisis and the appropriateness of these strategies to the crisis.

More so, the financial situation in most economies is sensitive and complex with no sufficient macro economic system having been formulated to avoid the spillover of the crisis to other economies. Consequently, the crisis is believed to cause lower economic growth, fear of investing, liquidity shortage and recession, if it goes unchecked.

Introduction

The subprime mortgage crisis refers to the current dilemma noticeable by cash flows problems in the worldwide banking set up caused by foreclosures that hastened in the United States in the year 2006 and spread to other counties causing worldwide monetary problems in the years 2007 and 2008.

The origin is traced from the rupture of the housing bubble in the US and a rise in non payments interest rates charged on subprime and the modifiable mortgage rates imposed on heavy borrowers’ who earn small incomes compared to the major or prime credit borrowers (Dodge David,2007). The inducement to borrow loan and the observable lasting tendency of mounting house prices led to borrowers to run for mortgages with the hope of being able to repay later at fair rates and conditions.

The major effects of the crisis included heavy losses incurred by the mortgage financiers who lend to default rate borrowers as they were incapable or reluctant to refinance the mortgage leading to some mortgage lending organizations to close down due to losses or bankruptcy. Secondly, many lending institutions minimized their lending tendencies and increased the interest to discourage borrowing hence the liquidity capabilities of the major economies forcing them to provide to banking institutions in order to lend to investors and borrowers (Bernanke, 2007).

Fed reaction

In responding to the subprime mortgage crisis the fed authority has made cash or liquidity readily available to the banking institutions mainly through its open market operations where banks are offered short term loans designed to maintain the fed’s fund rate at the intended favorable level.

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This rate has been maintained at 5.25% for a considerable length of period. In addition, the fed has similarly provided emergency liquid to banks to ensure they continue lending to the public through its well formulated discount window hence banks can access emergency loans at a discounted rate (IMF survey, 2008).

Due to the fact that the fed aims to maintain its fund rate, the discounted rate is normally higher to avoid the banks overusing the window services and ensure that they rely on open market operations (King Mervyn, 2007). More so, the fed requires financial institutions to submit high valued collateral chattels to access the discounted loans as an assurance of repayment.

This move assists in ensuring that discount window operations do not interfere with the normal open market rates that would consequently affect the banks lending rates in case the liquid available becomes excess.

On checking the subprime crisis, the fed additionally lowered the rate of accessing emergency loans at the discount window from 6.3% to 5.8% while maintaining the open market rates at the intended level of 5.3% (Charles Wyplosz, 2007). Further, the variety of the collateral possessions that would be required to access discounted loans was widened to include default mortgages among others. The lending period was consequently increased to ensure more cash is available to lending institutions to avoid further rise in interest rates due to financial institutions restricting their lending trends or tendencies.

Policy evaluation

The move by the fed to maintain the open market rates at the targeted level of 5.25% has been considered appropriate due to the fact that the inflation rate has consequently been maintained. The reluctance of the Fed to react at a faster speed through lowering its fund’s rate to increase the liquidity available is due to its concern on inflation rates.

Secondly, the fed reaction to maintain their fund’s rates while making discounted loans more affordable but at a higher rate than the open market loans calmed the strain on the credit market while still maintaining its monetary options in case the problem persists and threatens to cause recession as many people fear this could be the trend. Therefore, the reaction of the Fed has been considered more appropriate as the rate of inflation has been maintained and the strain on the financial market eased without interfering with the Fed monetary tools and options to deal with subprime crisis in future.

The ECB reaction

In reacting to the subprime crisis, the ECB released 94.8 billion Euros to 49 banks located in the region to ease the tension in the money market and make liquid more available to the financial institutions for lending to the public (AFP, 2007). In addition, the ECB has maintained its interest rates at 4% due to the rise of inflation in the course of the year from 2% to 3% with authorities predicting the inflation rate will remain higher than the usual targeted 2% for the better part of the year (Mark Landler, 2007).

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In addition, the bank is concerned with raising the economic growth feared to be declining than the other years. With prices of food and oil rising almost everyday the bank fears that the crisis will cause the second round consequences where workers will strike demanding for higher wages due to the rise in cost of living caused by rise in inflation (Dodge David, 2007).

In addition, the bank started to accept non tradable security assets as a reassurance of overnight borrowing by the banks but the central bank did not have to raise the range of possessions acceptable because the ECB accepts a wide range of chattels as loan security. The ECB decided to double the amount of money available in its open market operations while maintaining its interest rate usually set by the governing committee while reducing the cash available to the discount window by halve to ensure a balance and discourage overreliance of the banks on the facility (King Mervyn, 2007).

In addition, the ECB raised the number of banks and financial institutions that it was dealing with directly in order to ensure that its monetary policies are widely and effectively carried out or implemented. There are predictions that the governing committee may opt to lower their interests in order to encourage borrowing and make more liquid available to the public to avoid economic growth slowdown. More so, the ECB has expressed its commitment to make prices stable in the region as its main objective to avoid the adverse effects of the inflation.

Policy evaluation

The move by the European Central Bank to inject more cash on its open market operations has been considered necessary to ease the tension in its money market and install confidence to the public of the bank commitment to ease the financial burden and ensure that more people carry on with their saving and investment plans. Secondly, the move to keep the interest rates unchanged has ensured that the prices remain stable to avoid further rise in inflation in the economy (Dodge David, 2007).

In addition, the acceptance of a wide range of assets has ensured that more liquid is available to the public for borrowing easing the strain on the credit market while maintaining its policy options in future. However, many people have criticized the banks move to focus its interest on price stability while ignoring the financial stability of the economy (Good hart, Charles & Avinash Presaud, 2008).

Bank of England reaction

While both the Fed and the ECB decided to maintain their current interest rates, the bank of England on the other hand decided to lower its interest rates to 5.5% to ease the tension on the credit market and ensure that mortgages are refinanced easily and with less tension by borrowers (Mark, 2007).

However, the rate of inflation in the economy has exceeded the set rate of 2% symbolized by the rise in oil and food prices in the course of the year. The central bank authorities declared that there was no need for inflation fear as it will be counteracted by the ongoing strain in the money market.

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Furthermore, the bank has changed the amount of reserve requirements that must be kept with the central bank by lowering the amount to ensure that banks have enough liquid to lend to borrowers. Just like the Fed and the ECB, the bank of England further expanded the range of the collateral chattels that will act as the security for loan repayment to encourage overnight borrowing by making the process less restrictive. However, the bank expects the economic growth to slowdown due to lower investments undertakings and consumer demand caused by lack of enough liquid in the economy.

Policy evaluation

The cutting of the bank’s major interest rates is appropriate and relevant considering that mortgage holders are required to refinance them in the near future. Therefore, the strain on the money market was eased by the lower interest at this period of the subprime crisis where there is little cash available to the public.

Lower interest rates have encouraged borrowing as the borrowers are not prohibited by high interests (King Mervyn, 2007). However, lowering the interest rates at a time when the prices of most commodities are not stable might lead to further rise in inflation despite the authorities’ assurance of no further rise.

Secondly, the changes on the reserve requirements by the commercial banks is appropriate to make more cash available to banks for lending to public. In addition, the expansion of the collateral assets to include non tradable ones has encouraged banks and public borrowing tendencies from the central banks and from themselves.

Conclusion

The subprime mortgage crisis has the major effect of causing liquidity shortages among other problems. However, the problem seems to be spreading to other economies and affecting the sectors that are associated with real estates or mortgages especially that work closely with the US (Bernanke, B, 2007).

Major central banks of the prominent economies have responded to the crisis by formulating and implementing various monetary policies such as lowering interest rates like the bank of England, to encourage borrowing and make funds available to the public (King Mervyn,2007). Others have opted to raise the funds available for open market operations while maintaining their current interest rates to avoid rise in the inflation rates.

References

Bernanke, B. The Recent Financial Turmoil and its Economic and Policy Consequences, “Speech to the Economic Club of New York”, 2007.

Ecchetti, Stephen. A Better Way to Organized Securities Markets, “Financial Times. Web.

DiMartino, Danielle & Jon D. “The Rise and fall of Subprime Mortgages,” Economic Letter 2, Dallas: Federal Reserve Bank of Dallas, 2007.

Dodge, David. Turbulence in Credit Markets: Causes, Effects, and Lessons to be learned, “Speech to the Vancouver Board of Trade,” 2007.

Eichengreen, Barry and Donald Mathieson et al. Hedge Funds and Financial Market Dynamics, “Occasional Paper no. 166, Washington, D.C.: International Monetary Fund, 1998.

Economist, Rating Agencies: Measuring the Measurers. Web.

Good hart, Charles & Avinash Presaud. How to Avoid the Next Crash? “Financial Times” 2008, p.14.

Joint Economic Committee, U.S. Senate, the Subprime Lending Crisis, Washington, D.C.: Joint Economic Committee, 2007.

King, Mervyn. Turmoil in Financial Markets: What Can Central Banks Do? “Paper submitted to the Treasury Select Committee, House of Commons, (2007).

Leamer, Edward—Housing is the Business Cycle, “NBER Working Paper no.13428, 2007.

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