By Azan,amr.

2014

In 2008, many Western banks were badly affected by the Sub-prime crisis, which then has
severe and long-lasting consequences for the global economy.

1. What were the conditions and the events that contributed to the sub-prime crisis?
2. How does this sub-prime crisis affect the economy growth?
3. What measures did the US Government take to stabilize their financial system? Do you agree with
those measures taken? State your reasons

1. Introduction
If there is one particular thing that companies, individuals, investors and
governments will pray for not to happen, it will not be anything other than global
recession, which is defined by the international monetary fund (IMF) as global
economic growth of 3% or less(Muthe,2010). But this canker apparently has come to
stay with us. There were global recessions in 2008 and 2009 which saw many
individuals, investors, employees and governments wailing. Companies, individuals,
investors and governments wail during a period of global recession because during
this period, production (GDP), employment, investment, spending, capacity
utilization, household income and business profit fall. The subprime term refers to
the credit status of the borrower. The US economy entered a mortgage crisis in 2008
since the borrowers who are not eligible for the best interest rates were provided
loans. This led most of the lending institutions and hedge funds to collapse.



By Azan,amr.2014


2. Causes of subprime crisis
There is a firm belief that the price of the houses would not go down. Many people
also believed that the price of houses would continue to increase continuously over a
period of time. This created what is called Housing Bubble. People started to buy
expensive houses with the help of loans provided by financial institutions with low
interest rates. However, there was a steep fall in the housing crisis from 2005-2006.
The interest rate on the loans was increasing. The borrowers were not able to meet
the liabilities and found it difficult to afford homes (Lehrer, 2014).
However, people tried to increase the income and reduce the spending. They also
tried to negotiate a workout program and also refinanced. All these failed and people
were forced to resale their apartment. In normal days, bank would be able to recover
the amount they loaned at foreclosure (Patton, 2014). In this scenario, the bank was
not able to do anything since the home values fell to such an extent.
The mortgage crisis really heated up when more and more borrowers were not able
to pay their debts. This made bank and investors to lose money. Banks and other
lending institutions reduced the risk by not lending the money (Demyanyk and Van
Hemert, 2011). The main reason behind such an action was that the bank did not
know whether they would be paid back. Even for a bank to operate successfully,
money needs to flow in a proper manner. People all over the world saw financial
institutions failing and panic increased.
2.1Effects of subprime crisis on US economy
By Azan,amr.2014

The US entered a recession period and most of the people lost their jobs during
2008-2009. This increase in the unemployment rate made matters worse. The GDP
growth rate was very low. Exports of goods and service to countries like China,
Korea slow down (Tudor, 2009). Poverty has struck very badly in most parts of US.
The effect was worst hit in and around Midwestern cities such as Grand Rapids,
Michigan, Youngstown, although the effect was experienced in all parts of US.
Poverty started to hit hard in village areas when compared to cities.
People also started to lose their homes. Most of the people tried to increase the
income and reduce the spending. People started to spend less on buying food and
clothes. This led many business firms to slow down on their production scale. The
slowdown of business firms to produce goods led to increase in the price of goods
and services in the US market. Continuous increase in inflation rate led to economic
breakdown. This led to depression state in US economy.
People started to find it difficult to get approval for getting a credit card or an
approval for a mortgage. Even the best and well know qualified persons found it very
difficult to get the approval. Only 50 per cent of the business firms get approved for
the loans. Out of 10 home loans applied, only one application was approved. Such
was a case with US economy.
3. Measures to stabilize the financial system
The Federal Reserve along with central banks all over the world took several steps
to deal with subprime mortgage crisis.
US government helped the low income people to renegotiate their loans and stay in
their homes. The US government hoped that more money from low income families
will be free and would shift the balance between borrowers and lenders.
By Azan,amr.2014

The Federal Reserve also amended new lending rules for borrowers. The central
bank wanted to prohibit lenders from making high priced loans. The central bank
believes that the new rules would restore the confidence in the mortgage market.
The Federal Reserve and other central bank performed open market operations to
ensure commercial or member banks access to cash. These loans provided were on
short term basis. The Federal Reserve reduced the interest rate for member banks
for short term loans. The interest rate specified in the previous statement is called
discount rate in economics terminology. This ensured more liquid was available in
the member banks for the financial system to efficiently function.
The US government also introduced programs such as term auction facility, dollar
swap lines, term securities lending facilities, primary leader credit facility, commercial
paper funding facility, term asset- backed securities loan facility and also provided
assistance to individual institution.
The Federal Reserve has used the open market operations as their core monetary
policy tool to ensure their financial system function effectively (Grant, 2014). For the
financial system to function effectively, we need to control the money supply and
interest rate in the economy. This monetary policy would help to perform this task in
a more flexible manner when compared to other two monetary policy Reserve
Requirements and Discount rate.
The open market operations focus on interest rate targeting for a short term in the
debts market. This target rate is changed periodically in order to achieve and
maintain the interest rate target range. It also focuses on controlling money supply.

By Azan,amr.2014






References
Demyanyk, Y. and Van Hemert, O. (2011). Understanding the subprime mortgage
crisis. Review of Financial Studies, 24(6), pp.1848--1880.
Grant, J. (2014). The Fed's Subprime Solution crisis.. [online] Nytimes.com.
Available
at: http://www.nytimes.com/2007/08/26/opinion/26grant.html?pagewanted=all&_r=0 [
Accessed 25 Jul. 2014].
Lehrer, E. (2014). Subprime Borrowers: Not Innocents - BusinessWeek.
[online] Businessweek.com. Available
at:http://www.businessweek.com/debateroom/archives/2008/03/subprime_borrowers
_not_innocents.html [Accessed 25 Jul. 2014].
Muthe, RP (2010), Global recession: challenges and opportunities for Indian tourism
and hotel industry, International Research Journal, Issn-0975-3486, Vol.8.

Patton, M. (2014). Why The Next Financial Crisis Could Be Worse Than 2008.
[online] Forbes. Available
at:http://www.forbes.com/sites/mikepatton/2014/02/11/why-the-next-financial-crisis-
could-be-worse-than-2008/ [Accessed 25 Jul. 2014].
Tudor, C. (2009). Understanding the roots of the US Subprime Crisis and its
subsequent effects. The Romanian Economic Journal, 31, pp.115--148.

By Azan,amr.2014