Chris Moffatt

Professor Char Miller

Government 490: Technology of Money

Short Paper #1

In September 2009, 14.4% of all outstanding United States mortgages were delinquent or in foreclosure; this commonly became known as the subprime mortgage crisis. The mortgage crisis is a direct result of the “housing bubble” bursting abruptly where housing prices were elevating at a much higher rate than income rates. This essay will give a brief overview of the elements of the crisis including Troubled Asset Relief Program (TARP) funds, Adjustable Rate Mortgages, Subprime Mortgages, Investment Banks, Collateralized Debt Obligation (CDO) and Credit Default Swaps (CDS).

The Troubled Asset Relief Program is a governmental program signed into law by George W. Bush that allowed the United States government to purchase assets from financial institutions with the goal to provide financial market stability and to convince banks to resume lending as they previously would. Lack of regulation has been attributed as to why there has been so much money given, and possibly misused, but no noticeable increase in lending.

According to the Federal Reserve Board adjustable mortgage rates are, “loans with an interest rate that changes.” (www.federalreserve.gov). This means that monthly payments may increase even if interest rates do not, payments may not go down even if interest rates decrease, and one may have to pay back more than they borrowed even if all payments were punctual. Lenders may intentionally charge lower rates than fixed rate mortgages, but of course this charge is always subject to increase.

Subprime mortgage loans are riskier loans given to borrowers who may not have the income or credit history to qualify for normal mortgage loans. Subprime mortgage loans have a much higher rate of default than normal mortgage loans and the proportion of subprime loans increased dramatically from 2004 to 2006, about the time when the housing bubble burst.

Collateralized Debt Obligations are securities made up by a collection of bonds, loans and assets. These are separated by degrees of risk and the higher the risk, the more the CDO will yield. CDO’s increase risk about the value of the original assets more extensively. Bear Stearns, Merill Lynch and Citigroup all cited blunders pertaining to CDOs as the reason for their financial losses.

A Credit Default Swap is where the buyer makes payments to the seller so that in the event that it defaults, the buyer gets compensation. All of these negotiations are private and the lack of transparency hides the identities of the buyers and the sellers. This is especially controversial because in the case of the Lehman Brothers or General Motors the stakeholders may have actually benefitted financially from the company having to file for bankruptcy. Creditors benefit from bankruptcy because credit default swaps will pay them the full face value of their debt.

The subprime mortgage crisis appears to be a perfect storm of the housing bubble bursting, reckless lending by the banks to unqualified borrowers, potential corruption of private investors, a lack of transparency in the financial institutions, and a general deficiency of regulation.