Subprime Mortgage Crisis in the United States in 2007–2008: Causes and Consequences (part II)

Vaidotas Pajarskas,Aldona Jočienė

doi:10.15388/ekon.2015.1.5317

Abstract

This is the second part of the qualitative and quantitative research on the subprime mortgage crisis in the United States in 2007–2008. The main purpose of this research is to determine the factors and how they contributed to the subprime mortgage crisis, what their causal links and effects on the markets and the whole economy were, and to assess what actions could have been taken by the Federal Reserve and the Government in order to mitigate or prevent the consequences of the subprime mortgage crisis and the housing bubble. In order to obtain the results, the authors performed a qualitative analysis of the scientific literature on the course of events and their development that led to the subprime mortgage crisis and focused on insufficiently regulated home mortgage market expansion, the impact on subprime mortgage crisis of financial innovations and financial engineering, poorly evaluated systemic risks and policy undertaken by both the U.S. Government and the Federal Reserve before and after the crisis. The quantitative research focused on two main parts: firstly, the analysis of dependencies between the causes of subprime mortgage crisis and the consequences using the statistical and regression analysis; secondly, an alternative path the Government and the Federal Reserve could have taken in their policy actions, and the results they could have produced have been explored. The authors believe that the results of the research could give useful guidelines to the central bankers and government officials on how to make long-term decisions that can help in preparing for the financial distress, mitigating the consequences when the crisis strikes, accelerating the recovery and even preventing the crisis in the future.

Highlights

Since August 2007, global financial markets were shocked by catastrophic events and circumstances stemming from problems in the U.S subprime mortgage segment
This paper introduces three groups of the root causes of the U.S subprime mortgage crisis considered to be the main by the authors: 1) problems directly and related to the subprime mortgage lending practices; 2) causes related to the subprime mortgage securitizations; 3) causes related to the ability of financial institutions and public authorities to assess the systemic risks
The Federal Reserve replaced the “dot-com” bubble by the housing bubble, increasing money supply and keeping low interest rates for a prolonged period, while residential housing schemes too actively encouraged lending to low-income individuals, which later resulted in higher mortgage delinquency rates and reduction of residential construction volumes and prices

Summary

Introduction

Since August 2007, global financial markets were shocked by catastrophic events and circumstances stemming from problems in the U.S subprime mortgage segment. As interest rates rose and house prices flattened with loan value and turned negative in a number of regions, many stretched borrowers were left with no choice but to default as prepayment and refinancing options were not feasible with little or no housing equity (Kiff et al, 2007) This subprime mortgage crisis, marked by home foreclosures of enormous scale and illiquid mortgage-related securities which have created huge capital holes on the balance sheets of banks and financial institutions, has spilled over into the global economy, causing a global credit crisis and fuelling a deep, long, and painful recession (Moran, 2009). Control from above was ineffective and allowed banks and other financial institutions to freely participate in the risky and growing subprime mortgage securities market, without accumulating sufficient capital reserves, whereas the control and level of risk of investment banks in the total balance and the general expansion of activities in the market of subprime mortgages were treated in perfunctory manner, and due to the fragmented structure of control such risk was not fully assessed or disputed

Effects of alternative actions on the data table

SUMMARY OUTPUT Regression Statistics

SUMMARY OUTPUT

Findings

Conclusions and proposals