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The word µsubprime¶ has perhaps become the most often repeated word in the newspapers
lately. It¶s there everywhere. The credit crisis of 2007 started in the subprime mortgage
market in the U.S. It has affected investors in North America, Europe, Australia and Asia and
it is feared that write-offs of losses on securities linked to U.S. subprime mortgages and, by
contagion, other segments of the credit markets, could reach a trillion US dollars. It brought
the asset backed commercial paper market to a halt, hedge funds have halted redemptions or
failed, CDOs have defaulted, and special investment vehicles have been liquidated. Banks
have suffered liquidity problems, with losses since the start of 2007 at leading banks and
brokerage houses topping US$300 billion, as of June 2008. Credit related problems have
forced some banks in Germany to fail or to be taken over and Britain had its first bank run in
140 years, resulting in the effective nationalization of Northern Rock, a troubled mortgage
lender. The U.S. Treasury and Federal Reserve helped to broker the rescue of Bear Stearns,
the fifth largest U.S. Wall Street investment bank, by JP Morgan Chase during the week-end
of March 17, 2008.

Banks, concerned about the magnitude of future write-downs and counterparty risk, have
been trying to keep as much cash as possible as a cushion against potential losses. They have
been wary of lending to one another and, consequently, have been charging each other much
higher interest rates than normal in the interbank loan markets. The severity of the crisis on
bank capital has been such that U.S. banks have had to cut dividends and call global
investors, such as sovereign funds, for capital infusions of more than US$230 billion, as of
May 2008, based on data compiled by Bloomberg. Trillions of Dollars in various economies
have eroded, and it is said this is just a beginning. Companies are giving its employees
termination letters, governments are busy with monetary, fiscal and other measures to
minimize the impact of the meltdown. The stock market which was once dominated by
bullish expectations, only sometime back now faces a lull period. Economies, Rich or poor,
Big or Small around? the world have been affected by this mammoth crisis. Major investment
banks like Lehman Brothers, which withstood many market fluctuations in the past,
disappeared from the face of the earth. Thus the crisis becomes a kind of historical event,
which need to be studied, analyzed and finally lessons to be taken for the future. This study is
one such attempt and examines this phenomenal crisis in world economy.
The story starts from bad lending policies of major banks due to steadily rising home values
and a low interest? rate environment, the lenders relaxed lending standards and gave loans to
borrowers on recommendations of mortgage brokers (who were more interested in their
commission) that created sub-prime loans. These mortgages did not stay long in the
originating banks¶ balance sheets but were pooled together and sold to investment banks as
mortgage backed securities (MBS). The investment banks created derivative instruments
called collateralized debt obligations (CDOs) and sold them to various institutional investors
like hedge funds, pension funds, mutual funds and banks in all parts of the globe. Many
financial institutions, investment banks in particular, issued large amounts of debt during
2004±2007, and invested the proceeds in mortgage-backed securities (MBS), believing that
households would continue to make their mortgage payments due to the boom in house
prices. But as 2007 progressed, house prices began to decline and mortgages began to default
due to which? financial institutions and individual investors holding MBS suffered significant
losses. Thus the subprime loans spread throughout the financial system in the form of
securities backed by them, they were passed from original lenders to investment banks, and
then to all the institutions around the world. The default on these mortgages turned the MBS
portfolios ³toxic´ and exposure of financial institutions to these toxic subprime mortgages led
to their collapse which created a sudden wave of tremors throughout the financial system.

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 : Lehman Brothers, Goldman Sachs , Merrill Lynch , Bear Sterns
and Morgan Stanley, who had tremendous influence over financial markets all over the globe
suffered huge losses in the mortgage market due to their large exposure to devalued mortgage
backed securities and became victims of the financial turmoil in the US losing their original
identity.11 8. While there is not one standard? definition, subprime borrowers typically are
described as borrowers who have weakened credit histories that include payment
delinquencies, and possibly more severe problems such as charge-offs, judgments and
bankruptcies. These borrowers also may display reduced repayment capacity as measured by
such considerations as lower credit scores or higher debt-to-income ratios.

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The contributors of the crisis included the common borrowers, lenders, rating agencies,
financial institution, brokers as well as underwriters. They caused housing bubble to balloon
and then explode.
Causes of the Subprime Crisis (a) The Housing Downturn (b) Role of Borrowers (c)
Mortgage Fraud by Borrowers from US Department of the Treasury (d) Role of Financial
Institutions (e) Role of Securitization (f) Role of Mortgage Brokers (g) Role of Mortgage
Underwriters (h) Role of Government and Regulators (i) Role of Central Banks, and (j) Role
of Credit Rating Agencies

In the ongoing financial crisis leading to the fall of large investment institutions (e.g. Lehman
Brothers) all over the world, due to the flimsy ratings assigned by rating agencies to subprime
mortgages raised questions on the performance of credit rating agencies. Nonetheless, the
question is why had these investment institutions engaged themselves in these transactions
and what made investment banks so confident that they could easily sell them off? It was all
made possible by credit rating agencies who assigned high ratings to products based on risky
mortgages including bonds packaged as CDOs - causing investors to be misled as to the
quality and riskiness of these investments. The triple-A ratings given by a firm like Moody¶s,
encouraged investors to buy these securities, they forget about the underlying mortgages and
took these ratings as safe as other triple A securities. Rating agencies thus turn out to be the
central culprit in the mortgage bust as their opinions on the?underlying risks of the securitised
instruments have emerged as the crucial pivot in the functioning of the market. As home loan
delinquencies have risen, credit rating agencies started reviewing and lowering ratings on
residential mortgage-backed securities and for the pools of these loans i.e. collateralized debt
obligations