SUB PRIME CRISIS

Causes and Effects:

"The new group at the Fed is not equal to the problem that faces it. They need to speak
frankly to the market and acknowledge how bad the problems are, and acknowledge their
own failures in letting this happen. This is what is needed to restore confidence. There never
would have been a sub-prime mortgage crisis if the Fed had been alert. This is something
Alan Greenspan must answer for."
Dr. Anna Schwartz
The Sunday Telegraph
January 14, 2008

CAUSES
What caused the crisis? Initially many thought that it was due to incentive
problems in The U.S. mortgage industry. However, after the large economic
meltdown following Lehman Brothers' bankruptcy in September 2008, it
seems that much more was going on.
We argue that there was a bubble in real estate prices in the U.S. and a
number of other countries. The main causes of the bubble were loose
monetary policy, particularly by the
U.S. Federal Reserve, and the global imbalances. The combination of cheap
credit together with the easy availability of funds contributed to create the
bubble. Many other factors such as subprime mortgages, weak regulatory
structures, and high leverage in the banking sector exacerbated the effects
of the crisis. We consider possible reforms aimed at minimizing the
occurrence of future crises in the governance structure of central banks,
measures to reduce global imbalances, and changes in banking regulation.
Despite the considerable media attention given to the collapse of the market
for complex structured assets, some of which contain subprime mortgages,
there has been precious little discussion of why this crisis in confidence
occurred and in particular why some $3 trillion in private label structured
assets are being liquidated, with negative effects on banks, dealers, end
investors and the economy. Such a discussion, which is the primary goal of
this paper, will hopefully lead members of the financial community to

consider how the market for structured assets should change and evolve in
future.1
Fair Value Accounting
A significant factor in making the collapse of the market for structured assets
containing subprime debt a true catastrophe is the move to fair value
accounting, a process that was implemented last year but has been debated
for more than a decade. Fair value accounting is a new era notion that has
developed over the past two decades and was promoted by large segments
of the accounting and economics profession, as well as by leaders of the
financial services community. It was implemented last year by an arm of the
SEC known as FASB or the Financial Accounting Standards Board.
Up until 2006, the housing market in the United States was flourishing due to
the fact that it was so easy to get a home loan. Individuals were taking on
subprime mortgages, with the expectations that the price of their home
would continue to rise and that they would be able to refinance their home
before the higher interest rates were to go into effect. 2005 was the peak of
the subprime boom. At this time, 1 in every 5 mortgages was subprime.
However, the housing bubble burst and housing prices had reached their
peak. They were now on a decline.

1 This paper is based on an earlier article which appeared in the Jan-Feb 2008 issue
of GARP Risk Review and comments excerpted from The Institutional Risk Analyst.