Subprime Mortgage Crisis -- 4 Questions
What is "leverage"? How does leverage magnify a bank's profit and losses?
The term leverage refers to the use of someone else's money to create financial gain. In the mortgage industry, homeowners typically put down a small amount of money on a home, and borrow the rest in the form of a mortgage. This use of borrowed money for a large purchase is referred to as leverage. While the homeowner has only put down a small amount of money and has borrowed a fixed amount from a bank, he may gain money in the form of home equity as a result of having used leverage to buy his home, because in the meantime, his home has gone up in value. When a bank uses leverage, it can either gain money as its leveraged assets go up in value, or lose money as they go down in value (D'Hulster, 2009, p1). In the case of the financial crisis, the use of too much leverage without enough capital held in reserve along with large losses in the bank's assets helped create the crisis (Stephens, 2010, paras 5-6).
2. Discuss the principal causes of the subprime mortgage crisis
It is largely agreed that the subprime mortgage crisis originated in the U.S. housing price bubble that occurred in the first half of the 2000s. The market bubble was driven by several factors, including low interest rates between 2002 and 2004 that make mortgages affordable for Americans who were previously unable to own a home. Mortgages and housing prices alone were not the entire cause. The low lending rates encouraged Americans to take on other types of debt, with the result being that Americans began to carry extraordinarily high debt-to-income ratios which tied up larger and larger proportions of their income (Bernake, 2009, paras 7-8).
Many borrowers at all levels took on onerous mortgages with the expecting that they would be able to refinance quickly due to rising home values....
However, homes didn't continue gaining at the levels that occurred in the early 2000s, and the housing bubble peaked in 2005-2006 (Lahart, 2007, para 2). Borrowers who had relied on the rising value of their home to qualify them for a better mortgage were subsequently unable to refinance to more favorable terms, and had increasing trouble affording their mortgages and other debts. Although typically referred to as the subprime mortgage crisis, subprime borrowers were not the only types of borrowers who experienced problems. Borrowers of all types found that their debt levels combined with other factors to cause them to become delinquent and then to default on their mortgages.
A second cause was the creation of new investment products created largely from grouping of subprime mortgages. These mortgage-backed securities allowed greater investment in the booming American financial markets, including many investments by foreign firms Bernake, 2009, para 6-8). As mortgage defaults rose, the value of mortgage-backed securities plummeted, and companies that relied on these products for liquidity found that they no longer had the assets they had relied upon.
1. What role does bank regulation play in preventing banking crises?
Crises can be prevented in two ways: by avoiding crisis situations in the first place, or by acting quickly to minimize situations that are on the verge of becoming crises. Bank regulations are designed primarily to keep banks from entering crisis situations in the first place, and should that fail, to resolve harmful situations quickly and efficiently.
Regulations typically work in several ways. They can require banks and other financial institutions to have a certain amount of liquid capital in reserves, which is supposed to ensure that banks can always pay any obligations that become due immediately. Of course, the bank can't have liquid savings…
