Sunday, August 12, 2007

The Subprime Mess

In reaction to the telecom/dot-com/9/11 bust, the Federal Reserve reduced the Fed Funds target (Interest rates) down to 1%. This boosted the real estate market as low mortgage costs combined with investment hype to create a new speculative bubble in housing. Competition increased between banks and other mortgage providers to get in on this market and down payment requirement decreased as well. Loans were given to people with little equity for a down payment and often with less than stellar credit histories, discounting credit reporting algorithms such as FICO. The questionable loans were then bundled, packaged and sold in secondary markets. This allowed mortgage originators to replenish their ability to legally make more loans. It also created new levels of risk and meant that lending was now financed by investors rather than depositors.

These financial instruments have become a crucial mechanism in the new global system of financial hedging. They have become the foundation of, the collateral for, highly leveraged trading strategies that have, for instance, pushed the Dow to 14,000. Now, as their collateral gets devalued, these traders face margin calls – they have to put up more money or default on their loans. Subprime loans make up only 10% of the mortgage market and only a small percentage of them are in trouble but the bundled loans have lost their attractiveness. The combination has created a credit crisis had has only been partially alleviated by the Federal Reserve’s recent infusion of capital into the banking system.

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