Subprime Crisis and the Global Financial Markets

Readers Question: To what extent can the subprime crisis affect the global financial market?

The subprime crisis refers to the rising number of defaults on US subprime mortgages. Basically, US mortgage companies sold a lot of inappropriate mortgages to people on low income and poor credit histories. Rising interest rates, and falling house prices are causing many of these mortgage owners to struggle with repayments. Therefore, many mortgage companies have lost significant amounts of money. Some of the leading US subprime mortgage firms have gone under and bankrupt. If it was just mortgage companies who went bankrupt, it wouldn’t be so much of a problem.

However, many of these mortgages were financed through securitization. Basically, the mortgage companies would lend the money to homeowners but would finance the mortgage loan by selling ‘mortgage bundles’ to other financial institutions. Basically, mortgage loans were financed by many different financial companies, not just the mortgage companies.

In the US, upto 70-80% of mortgage loans were financed by securitisation. In the UK, the rate is much lower about 21%. The only British bank to get into trouble was the Northern Rock. The Northern Rock, unsurprisingly had the highest rate of 61%.

Therefore, many banks and financial institutions have been left nursing large losses resulting from losses in the subprime markets. The consequence of this is that many banks are now reluctant to lend money. In particular they are reluctant to buy any bundles of mortgage debt. Therefore, we have a shortage of funds in the capital markets. The consequence of this shortgage of funds is to increase the cost of borrowing. Therefore, many loans and mortgages will become more expensive because of rising bank rates. (note these bank rates are separate to the central bank base rate.

This shortage of funds is effecting financial markets which don’t have any direct connection with the US subprime markets.

Furthermore, this shortage of funds has precipitated a decline in consumer and investor confidence. It has been a contributing factor to the decline in stock markets.

When will the subprime crisis end?

Unfortunately, there are more mortgage deals coming to the end of their introductory period. This means that when the rates increase, there are more people at risk of defaulting. This could cause a further set of losses and undermine the financial markets even more.

However, lower interest rates in the US will help stabilise the market to some extent.
Backed by the government, Mortgage companies are also looking at ways to avoid interest rates increasing too much.

A Humorous explanation of the subprime crisis 

Effects of Freezing subprime rates