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The

subprime mortgage crisis

is an ongoingfinancial crisistriggered by a dramatic rise inmortgage delinquencies and foreclosures in theUnited States, with major adverse consequences for banks andfinancial markets around the globe. The crisis, which has its roots in the closing years of the 20th century, became apparent in 2007 and has exposed pervasive weaknesses infinancial industry regulation and the global financial system.Many USA mortgages issued in recent years were made tosubprimeborrowers, defined as thosewith lesser ability to repay the loan based on various criteria.

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When USA house prices began todecline in 2006-07,mortgage delinquencies soared, andsecurities backed with subprime mortgages, widely held by financial firms, lost most of their value. The result has been a largedecline in thecapitalof many banks and USAgovernment sponsored enterprises, tightening credit around the world.

Background

Factors Contributing to Housing Bubble – Diagram 1 of 2Domino Effect As Housing Prices Declined – Diagram 2 of 2The crisis began with the bursting of the United States housing bubble

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and high default rateson "subprime" andadjustable rate mortgages(ARM), beginning in approximately 2005–2006. Government policies and competitive pressures for several years prior to the crisis encouragedhigher risk lending practices.

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Further, an increase in loan incentives such as easy initial termsand a long-term trend of rising housing prices had encouraged borrowers to assume difficultmortgages in the belief they would be able to quickly refinance at more favorable terms.However, once interest rates began to rise and housing prices started to drop moderately in2006–2007 in many parts of the U.S., refinancing became more difficult.Defaultsandforeclosureactivity increased dramatically as easy initial terms expired, home prices failed to goup as anticipated, and ARMinterestrates reset higher.Foreclosuresaccelerated in the United States in late 2006 and triggered aglobal financial crisis through 2007 and 2008.During 2007,

nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from2006.

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Financial products calledmortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, had enabled financial institutions and investors aroundthe world to invest in the U.S. housing market. Major banks and financial institutions had borrowed and invested heavily in MBS and reported losses of approximately US$435 billion asof 17 July 2008.

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Theliquidity andsolvency concerns regarding key financial institutions drove central banks to take action to provide funds to banks to encourage lending to worthy borrowers and to restore faith in thecommercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions, assuming significant additional financial commitments.The risks to the broader economy created by the housing market downturn and subsequentfinancial market crisis were primary factors in several decisions by central banks around theworld to cut interest rates and governments to implement economic stimulus packages. Theseactions were designed to stimulate economic growth and inspire confidence in the financialmarkets. Effects on global stock markets due to the crisis have been dramatic. Between 1 Januaryand 11 October 2008, owners of stocks in U.S. corporations had suffered about $8 trillion inlosses, as their holdings declined in value from $20 trillion to $12 trillion. Losses in other countries have averaged about 40%.

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Losses in the stock markets and housing value declines place further downward pressure on consumer spending, a key economic engine.

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Leaders of the larger developed and emerging nations met in November 2008 to formulate strategies for addressing the crisis.

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[edit] The mortgage market

Main articles:Subprime crisis background informationand Subprime crisis impact timeline

Number of U.S. household properties subject to foreclosure actions by quarter.Subprime lendingis the practice of lending,mainly in the form of mortgagesfor the purchase of residences, to borrowers who do not meet the usual criteria for borrowing at the lowest prevailingmarket interest rate.Thesecriteriapertain to the borrower'scredit score, credit history and other factors.

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If a borrower is delinquent in making timely mortgage payments to the loan servicer (a bank or other financial firm), the lender can take possession of the residence acquiredusing the proceeds from the mortgage, in a process calledforeclosure.The value of USA subprime mortgages was estimated at $1.3 trillion as of March 2007,

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withover 7.5 million first-liensubprime mortgages outstanding.

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Between 2004-2006 the share of subprime mortgages relative to total originations ranged from 18%-21%, versus less than 10% in2001-2003 and during 2007.

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In the third quarter of 2007, subprime ARMs making up only

6.8% of USA mortgages outstanding also accounted for 43% of the foreclosures begun duringthat quarter.

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By October 2007, approximately 16% of subprime adjustable rate mortgages (ARM) were either 90-days delinquent or the lender had begunforeclosureproceedings, roughlytriple the rate of 2005.

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By January 2008, the delinquency rate had risen to 21%.

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and by May2008 it was 25%.

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The value of all outstanding residential mortgages, owed by USA households to purchaseresidences housing at most four families, was US$9.9 trillion as of year-end 2006, and US$10.6trillion as of midyear 2008.

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During 2007, lenders had begun foreclosure proceedings on nearly1.3 million properties, a 79% increase over 2006.

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As of August 2008, 9.2% of all mortgagesoutstanding were either delinquent or in foreclosure.

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936,439 USA residences completedforeclosure between August 2007 and October 2008.

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[edit] Credit risk

Understanding financial leverage.Credit risk arises because a borrower has the option of defaulting on the loan he owes.Traditionally, lenders (who were primarilythrifts) bore the credit risk on the mortgages theyissued. Over the past 60 years, a variety of financial innovations have gradually made it possiblefor lenders to sell the right to receive the payments on the mortgages they issue, through a process calledsecuritization.The resulting securities are called mortgage backed securities (MBS) andcollateralized debt obligations (CDO). Most American mortgages are now held by mortgage pools, the generic term for MBS and CDOs. Of the $10.6 trillion of USA residentialmortgages outstanding as of midyear 2008, $6.6 trillion were held by mortgage pools, and $3.4trillion by traditional depository institutions.

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This "originate to distribute" model means that investors holding MBS and CDOs also bear several types of risks, and this has a variety of consequences. There are four primary types of risk:

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1.Credit risk - the risk that the homeowner or borrower will be unable or unwilling to pay back the loan;

Asset price risk - the risk that assets (MBS in this case) will depreciate in value, resultingin financial losses,markdownsand possiblymargin calls;

Liquidity risk - the risk that a business entity will be unable to obtain financing, such asfrom thecommercial paper market; and

Counterpartyrisk - the risk that a party to a contract will be unable or unwilling to upholdtheir obligations.