Causes of Sub-prime crisis

and
Public Intervention





ATM TARIQUZZAMAN
Executive Director
Securities and Exchange Commission
Dhaka, Bangladesh
atm_zaman@hotmail.com

DR. QUAMRUL ALAM
Department of Management
Monash University
Australia.
Quamrul.alam@buseco.monash.edu.au


MOHAMMAD ABU YUSUF
Department of Management
Monash University
Australia
e-mail: mohammad.yusuf@buseco.monash.edu.au; ma_yusuf@hotmail.com





Corresponding Author: ATM Tariquzzaman
e-mail: atm_zaman@hotmail.com

1

Causes of Sub-prime crisis
and
Public Intervention


Abstract: This paper examines two issues: (i) the underlying causes of subprime lending
and resultant crisis that severely damaged the US and world financial markets; and (ii) the
rationality of state intervention in such crises. A comprehensive analysis of the subprime
crisis suggests that excessive deregulation of the financial system, lax regulation,
excessively accommodative monetary policy, bad lending and housing bubble have been
responsible for the subprime crisis and global financial meltdown. Withdrawal of the state
from financial markets due to over confidence in the market and irrational behaviour by the
borrowers, lenders and investors driven by greed aggravated the subprime crisis.
Keywords: Subprime, Financial Crisis, Organizational leadership, Layoff, Strategic decision
making
2


1. INTRODUCTION
The financial market has been dramatically changed in the last few months as the subprime
mortgages meltdown in the USA dried up credit markets and funding liquidity (White 2008) and
created a ripple effect in the global economy (Harmon 2008). The impact of the global financial
crisis, first felt in J uly 2007 when Bear Stearns, the fifth largest investment bank in the US ,
announced that two of its mortgage investment funds, worth about $US 1.5 billion, had literally
no value left in them (Nason 2007). Then Lehman Brothers opted for the biggest bankruptcy in
US history (The New Age, Dhaka, 8 December, 2008).
The US government also came up with a $US700 billion rescue fund to buy a stake in a broad range
of financial companies (The Australian, 5 November, 2008). Central banks of different countries
across the world are slashing interest rates to battle the deepening global crisis. In a globalized world
where nations are increasingly interdependent, the downturn in the worlds largest economy has had
global ramifications. The US downturn is sweeping across the world- Every nation, every government
and every economy is affected (Rudd, 2008). The subprime crisis and resultant economic recession
are having significant impact on organizations management practices. Unlike normal circumstances,
executives in charge of managing enterprises are now focusing more on minimising losses instead of
maximising profits. Strategically, organizational leaderships are increasing their focus on reducing
(through layoff, cutting back shifts/working time) or relocating their workforce (Ernst and Young
2009) and resorting pay cuts with a view to reducing costs and avoid bankruptcy. For instance,
Holden are cutting back shifts in order to slow production (King 2009). Pacific Brands decided to
move its production offshore (axing more than 1800 jobs in Australia) in an effort to reduce costs
(Schneiders, Sharp & Murphy 2009). Organizations are increasingly getting it difficult to access trade
credit from banks/lenders. Critical thinking and strategic decision making by business leadership
became essential to weather this difficult period. The ongoing financial crisis rooted in subprime
lending has put enormous pressure on CEO/Boards of enterprise to manage/adjust their workforce
wisely and meet cash requirements so that businesses do not suffer in the long run from want of
skilled and experienced staffing. This paper contributes to the existing literature by demonstrating
3

how highly decentralised and weak regulatory architecture created conditions for the near collapse of
the global financial system that forced governments of major economies to come up with rescue
package . The crisis is so acute that the G-20 leaders (in Pittsburgh meeting) had to reach a strong
consensus'' on firmer oversight of the global financial system and measures to curb excessive
executive pay (Davies, 2009). This paper provides a brief description of the precursors of subprime
lending in section 2. Section 3 discusses the factors responsible for the subprime crisis. Section 4
examines why government intervention becomes necessary in the event of financial meltdown and
Section 5 offers some suggestions for improvements in the financial regulatory and monitoring regime
to minimise the recurrence of such crises. Section 6 concludes the paper.
2. PRECURSORS OF SUBPRIME LENDING AND ITS GROWTH
Subprime mortgages are residential loans extended to individuals who do not qualify for
prime credit, i.e., individuals who have a higher likelihood of default (J onker 2008:9) and
are generally not eligible for credit from traditional sources. It represents mortgage lending
that allows the unsuitable borrowers to get credit those who for a variety of reasons would
otherwise be denied it (Chomsisengphet & Pennington-Cross 2006). Subprime borrowers
are high risk borrowers as they are often unable to offer a down payment, they have a record
of being unable to pay debts and they do not have income source. In the case of those who
have income, their credit liability is disproportional to that income.
Low global interest rates arising from high levels of global liquidity
i
(such as huge surpluses
accumulated in China, J apan and the OPEC nations which match the savings deficits in the
USA
ii
) contributed to rapid credit expansion. This credit expansion resulted in high asset
prices which preceded the crisis. The US government policy of interest rate cuts, tax
incentives on mortgage loans and encouragement for spending and lending initiated during
1980s created the policy platform for subprime lending. In the US, it was Greenspans
extraordinarily low interest-rate policy at the Federal Reserve that provided the extra fuel for
subprime lending and heated up the housing sector of the US economy (Foo 2008).
Subprime loans went to borrowers who had never qualified for a loan. Relaxation of
mortgage credit standards since 1977 and the enactment of the Community Reinvestment Act
4

(CRA), encouraging banks to extend more credit to the communities in which they operated,
created an environment for a subprime credit bonanza. The First-time Homebuyer
Affordability Act 1999 and the American Homeownership and Economic Opportunity Act
200l, eased financing home buyers down payments and house loan provisions to home
buyers (Fisher, 2001): Borrowers are being approved for loans that they would have been
turned down for [sic] just a year or two ago (Crum 2000).
Banks became popular with lower income and minority borrowers as lenders promised loans
with less paperwork, quick approval and no down payments. Banks and financial
institutions seduced the new borrowers(who were signing up to subprime deals) by easy- to-
get loans and attractive short-term interest rates (commonly known as teasers); but they
actually had to lock in to higher rates, reset often double the original rate after two years a
rate they could hardly afford (Brummer 2008).
Lack of due diligence
iii
resulted in different types of subprime loans. Some (home) loans
required little or no proof of a borrowers ability to meet repayments known as low
documentation (low doc
iv
) or no documentation (no doc) loans while other loans needed
no proof of income or credit history. Other types of mortgages included jumbos-
particularly large loans which were disproportionate to borrowers incomes or house values.
Mortgages were also sold by brokers and intermediaries without assessing the buyers
affordable capacity.
3: CAUSES OF THE SUBPRIME CRISIS
High liquidity of capital and its global movement, US government policy coupled with
imprudent behavior on the part of both lenders and borrowers and poor corporate
governance can be linked to the massive subprime loans that ultimately turned into the
subprime crisis. Self interest (greed) by the subprime lenders and Government Sponsored
Entities (GSEs) (i.e. Fannie Mae and Freddie Mac) are also liable for escalating the crisis.
Greed had triumphed over the traditional banking virtue of prudence (Brummer 2008:53).
These government-backed mortgage companies were aware of the risks they were
shouldering; yet they invested heavily in the subprime and alternative mortgage market,
5

ignoring the warning about the risks and probable losses of their investments in mortgage
backed securities. Warnings were raised by Fannies risk officer that many of the loans
would be susceptible to losses if home prices fell. Concerns were also raised about the
authenticity of the rating agencies risk assessment. The practice of these two GSEs of
buying so- called no-income, no-asset (NINA) mortgages allowing borrowers to get loans
without showing or verifying their income or assets was also opposed by the risk officer
(Hagerty 2008). Still the GSEs continued with their reckless lending practices. They lent
more than $US30 million between 2003 and 2007 but their irresponsible decisions have
resulted in billions of tax payers money bailing out financial organizations (Hughes 2008).
Easy availability of subprime credit not only resulted in the subprime crisis and, ultimately
in economic recession, but also developed a speculative consumption psyche among the
consumers for commodities which seems unaffordable to them at their present income
stream. The consumption psyche, coupled with easy access to credit cards increased the
possibility of more loan defaults by the consumers, thus aggravating the credit crisis further.
The causes of the subprime crisis are many and complex. The odious partnership of banks,
real estate companies, home building and GSEs which was formed under the home ownership
policy of the US govt to support affordable housing was the root cause of the subprime crisis
(Whalen 2008). The homeownership policies pursued under the Clinton administration
(namely National Home Ownership Strategy which had its mandate in the Community
Reinvestment Act (CRA), 1977) with a view to extending home loans to many who could not
afford them were instrumental in massive subprime lending. The partnership has been called
odious because it was almost unprecedented for regulators to forge close partnership with
those whom they have been charged to regulate. The CRA does not prescribe specific criteria
for evaluating the performance of financial institutions, but stipulates that the evaluation
process should accommodate the situation and context of each individual institution
(Demyanyk and Hemert 2008).
The specialised agencies who disbursed most subprime loans were not subject to the safety
and soundness regulations(as they are not deposit taking institutions) that apply to federal
6

or state banks, leaving the door open for fraud and abuse. These entities were less closely
monitored under the Home Ownership and Equity Protection Act, 1994 (HOEPA) and the
CRA. The outcome was a marked increase in abusive and predatory lending
v
(Schumer and
Maloney 2007).
Subprime lending created favourable conditions (through housing loan on easy terms and
conditions) for increased demand for housing loans which in turn enhanced home ownership
during the bubble years. The housing bubble was a major cause, if not the cause of the
subprime crisis. The perception that house prices go only in one direction i.e., go up year after
year
vi
created an atmosphere among lenders and financial institutions towards relaxing their
credit terms and risking default. Expansion in credit following easy credit terms has been an
important factor in asset price boom and bust cycles in the US and in other countries such as ,
J apan, Norway, Sweden, Finland
vii
and Mexico in the recent past. When the central bank
increased interest rates (tightened monetary policy) 17 times from 1% to 5.25% and imposed
reserve requirements in 2004-06 to moderate credit expansion with the motive of fighting
inflation, the bubble burst. Asset prices collapsed. Falls in asset prices imposed significant
strains on the banking sector (Allen and Gale 2007; Katalina and Bianco 2008). Financial
institutions holding real asset and stocks with falling prices (or with loans to the owners of
these assets) suffered greatly because payments are often missed by borrowers and banks
foreclose on the loans. The For Sale signs were thus seen everywhere (Brummer 2008).
However, the lenders could not recover the full amount of their credit by liquidating the assets
as the reduced asset prices become inadequate to cover their loans (as their loan amount is
fixed). This resulted in widespread defaults and retrenchments in the financial system. This
in turn exacerbated the problem of falling asset prices (negative asset price bubble.
This scenario suggests that expansionary credit policy and the occurrence of significant rises
in asset prices, and subsequent fall in asset prices (property boom and bust) are symbiotically
related. Expansionary credit policy led to boom in asset (housing) prices. This asset, especially
in the housing boom, caused a kind of madness in lenders attitude to approve any amount of
loans irrespective of the value of mortgage assets. In this regard, it is worth noting in one
7

instance, a couple were given loans worth $15 m on a house bought (with no down payment)
for $1.16 m. This couple then drew $333,000 to spend on consumer goods and lived in a nice
home for three years before walking away (The Economist, 29 Nov,2008:86). This madness
generally attracts everyone other than the few who can resist the temptation of buying a house
in a rising market with an easy loan. The symbiotic relationship between credit policy, asset
prices and financial crisis is shown in Figure 2(in appendix)
Figure -1 to be inserted here
With the collapse of the housing bubble came high default rates on subprime, Adjustable Rate
and Alt-A(near prime) mortgages. Significant falls in asset prices (housing bust), along with
high debt have led to weak balance sheets, resulting in widespread defaults and insolvency
(Davis and Karim 2008). The bursting of the housing bubble has become a direct cause of the
breach of trust among market players. Market players are unwilling to lend to each other,
because they are not sure they will be repaid. Many investments that were rated AAA turned
out to be junk when the housing bubble burst (Krugman 2008). Nobel laureate Krugman
believes the causes of the crisis are ideological: I believe that the problem was ideological:
policy makers, committed to the view that the market is always right, simply ignored the
warning signs about a potential subprime crisis (Krugman 2007).
Lower capital adequacy of banks deepens the financial crisis because it reduces banks
robustness to shocks. Although banks risk adjusted capital adequacy ratio appears sound,
securitisation created hidden difficulties for banks (Davis and Karim, 2008). The Subprime
crisis was aggravated as the banking system was not better regulated with an adequate
capital-asset ratio. The Federal Reserve and other agencies waited until it was too late before
trying to tame the excesses in the financial sector. Before 2007, Federal Reserve and
treasury officials praised subprime lenders for helping millions of families buy homes for
the first time. They were more occupied with the dream of providing people with home
ownership than in safeguarding the interests of depositors and the broader society (Andrews,
2007). It looks like a popular election campaign approach.
4 MARKET FAILURES AND GOVERNMENT INTERVENTION
8

The subprime crisis and the resultant financial meltdown forced the US and other developed
economies to come forward with massive financial support to rescue troubled banks and
financial institutions. Governments around the world had to devise fiscal stimulus packages
and take monetary measures to cut interest rates. The US government bailout package of
$700 billion became its biggest intervention in the financial system since the Great
Depression (Hughes & Guy 2008). The bailout packages and other government interventions
are due to market failure in three main tasks: to manage risk, mobilise savings, and allocate
capital (Stiglitz, 2008). The proponents of unregulated capitalistic market economy rely
overly on market based solutions and they consider that the market will automatically correct
imperfections. In this global crisis, it is evident that sole reliance on the market may be
harmful for society when the market itself is overly optimistic. The recent collapse of the
financial markets has already raised questions about the sustainability of the unregulated
capitalistic system. We call it unregulated because some non-bank subprime lenders were not
subject to any regulations. For instance, a lot of the subprime loans were lent by independent
mortgage brokers who were not regulated or insured by the Federal Deposit Insurance
Corporation (FDIC) (Harmon 2008). Some may say (and some have already expressed their
view) that capitalism has lost its relevance. We argue that capitalism is not at risk. It is the
excessive reliance on the market, too much deregulation and excesses by financial institutions
that are responsible for the financial collapses.
Reasons for government intervention
The recent turmoil in the global financial system, the behaviour of corporate executives, the
role of rating agencies and distorted market information that led to consumers going crazy
clearly suggest that the market led model is not always a perfect one. The crisis illustrates
how financial intermediaries, banks, and brokers deceived people and harmed their interest in
terms of loss of home ownership. Millions of homeowners in the US have defaulted on their
mortgage payments and are in danger of losing their property (Baaquie 2009).
Compelling subprime borrowers to default on unbearable loan payments under complex
subprime loan covenants (such as 2/28, 3/27 adjustable rate mortgages ), leading to millions
9

of homeowners losing their homes , the collapse of banks and other financial institutions
inflicting harms on investors and drying up inter-bank credit
viii
and loans to small and
medium sized firms created a situation where its ill effects affected lives over and above the
loss of homes. Against this backdrop of deregulated markets going to the wall, governments
had to step in to provide security to multiple stakeholders (who rely on the financial system
for loans, dividends, jobs and other financial services). For example, the UK government
were being forced to bail out the previously high ranking bank to the tune of 30 billion
pounds. The US government rescued Citi-group by guaranteeing $US306 billion of troubled
mortgage assets (held by Citigroup) and injecting another $US20 billion in capital. In
September, 2008 the US government committed $US700 billion towards rescuing the leading
financial institutions and injecting liquidity into the US economy. Similar steps were taken by
the UK and other European Union countries costing a huge amount of public money (Baaquie
2009). The examples of state intervention mentioned so far demonstrate the reality that in a
welfare state, governments have an obligation to protect investors, taxpayers and the
shareholders from the moral hazards of financial intermediaries. The pursuit of self- interest
(greed) led these institutions to engage in socially destructive activities that ignored even the
interests of their own shareholders.
Reposing sole confidence in the market and treating the market as the only saviour seems
somehow a mistaken concept. Neve, Luetchford & Pratt commented (2008:3) under neo-
liberalism the Market is treated as universal, a trans-historical and trans-cultural entity; it is
naturalised and reified, rather than thought of as a set of social relations; it is treated as a
given rather than the result of a historical process with complex social actors. This is not
always the case. Market forces manipulated the weak regulatory regime and as a result failed
to correct market imperfections. The subprime crisis and the resultant global economic
recession is largely the result of the excesses of financial market capitalism (Wood 2008).
There are examples where market could not always emerge as protectors of the public good
by rectifying its imperfections. In particular unfettered markets are not self-correcting and
there always remains an important role for government to play in the economy (Stiglitz
10

2008). It is to be noted that government intervention is not without its demerits. It was
government policies (lower interest rate, tax deductibility, CRA etc) which prompted initially
large scale subprime lending. Once the subprime crisis occurred, government intervention
and rescue packages become inevitable options to bolster market confidence and keep
financial institutions afloat. The US Treasury has already spent almost all the first US$350
billion tranche of the Troubled Assets Relief Program on top of its US$ 700 billion bailout
package (Australian Financial Review, 24 November 2008). The UK government has
nationalised Northern Rock which went bankrupt in September, 2007(Baaquie,2009).The
US$19 billion bailout package for three automotive companies is a clear sign that state
intervention is the last resort when all market mechanisms fail.
Socialists may celebrate the recent government interventions in the financial system
(government guarantees to bank liabilities and central banks providing cash to financial
institutions) as the victory of socialistic ideology and the end of capitalism. We however,
disagree with that notion. It is not capitalism that has collapsed; rather it is parts of the
financial system
ix
that are in serious difficulty. Edwards (2008) argues, Capitalism is not in
danger, but there is no doubt that some aspects of the way the global economy works needs
serious thought. The issues that need serious thought include among others, the transparency
of risk, the role of rating agencies, capital adequacy, asset valuation and imprudent behaviour
by lending agencies. Capitalism does not mean dismantling of regulations. Rather proper
regulation and reforms are necessary to allow capitalism work in citizens best interests.
Interventions to bail out Citigroup, Fannie Mae and Freddie Mac, AIG, Northern Rock etc.,
using public money, may be beneficial in the short term but it is most likely there will have
long-term impacts (such as moral hazard) for rewarding bad behaviour. Corporate boards of
the institutions and their allies who were instrumental in creating the crisis should not be
allowed to get off scot free. Reckless lending and borrowing, which is to be contained would
rather be encouraged by public guarantees. To avoid such global catastrophe in the longer
term, revamping the regulatory architecture for the global financial system with agreed
11

variations is an important requirement. Public guarantees to reenergise the financial sector
worldwide show that the state is the bearer of capital.
5. HOW COULD THE RECURRENCE OF FUTURE CRISES BE MINIMISED?
It is well accepted that no model or regulatory regime is perfect. No amount of fine tuning of
regulations and risk measurement can be a sufficient and perfect response to the increasing
complexity in global financial markets (Hildebrand 2008). There are human limitations.
Complete elimination of the recurrence of such events and crises is unrealistic. However,
streamlined and tight regulations with a more ethical corporate governance regime could
minimise such recurrence. Different suggestions are already on the table for a global
response. Quiggin (2008:62) proposed a system of narrow banking where regulated and
guaranteed banks are confined to a specific set of low risk activities with well established
accounting rules. The following are some of the areas where improvements could be made
to reduce the possibility of recurrence of such crises:
Basel II needs reform
The new capital adequacy rules of Basel II depend largely on the use of credit agency ratings.
The rating agencies themselves lack credibility. Given the lack of credibility of the rating
agencies in the structured credit market turmoil, allowing these agencies to perform a quasi-
regulatory role in relation to capital adequacy by Basel II seems inappropriate (Melbourne
Centre for Financial Studies, 2007). Basel II rules set by the Basel Committee on Banking
Supervision have a degree of national discretion. Therefore, national governments should set
tight capital requirements for banks that are in conformity with their exposure to operational
risks (including risks attached with dealing in structured financial products) and help them
secure sufficient capital to cushion against losses. In other words, banks' reserve requirements
should be tailored to the riskiness of their customers.
Global financial watchdog
Over the last few decades the world capitalist order has faced a series of problems which
have struck particularly the global financial system (Beams 2008). The world financial
market is now more interdependent and interrelated than ever before. The globalization of the
12

world financial system not only brought benefits in terms increased trade and easy and
cheaper access to capital, also allowed US bankers to export the results such as the subprime
crisis, the collapse of the share market, increased unemployment, and social and
psychological stress, all costing many countries billions of dollars for their greed and
mistakes (Brummer 2008). It is apparent that a global financial institution to monitor and
control the financial system with a view to protecting consumers and investors interests is
absent. Such international institutions are in place to monitor and regulate other cross border
economic and trade activities, for example the WTO for trade facilitation and dispute
settlement, the IMF for currency and exchange rate stabilization, the World Bank for
financing development activities, etc. No such institution exists to monitor and guide
international financial markets. So a global financial watchdog is a necessity.
Credit check
It is also necessary on the part of the government to bring about some changes in the
legislation to ensure that lenders must verify a borrower's ability to pay and to promote
fairness, financial stability and social justice. Moreover, margin requirements (safety margin
and buffer) could be introduced in lending where borrowers obtain loans on the basis of
inadequate collateral.
Asymmetry in incentive structure (where profits are shared by employees as bonuses but
losses are borne by banks, shareholders etc) motivates bank employees to take a short- term
view and excessive risk. This asymmetry should be reduced and banks need to adjust their
incentive structures to force bank employees exercise due diligence in lending and
investment.
6. CONCLUSION
Subprime lending is not the source of all evils. It is simply the manifestation of a disease
that has been growing in structured financial products for the last couple of years. The
collective actions of uninformed residential mortgage borrowers
x
, financial intermediaries,
rating agencies and poorly informed irrational exuberant investors in the absence of proper
regulations have led to the growth of the subprime market. Growth in subprime lending
13

ultimately turned into global financial meltdown causing severe adverse consequences for
home owners, investors, lenders, employees and tax payers. The top executives of
enterprises are under acid test how to face the crisis and survive if not grow in this difficult
time. It seems that, a totally decentralised, ineffective and fragmented regulatory regime has
weakened the fundamental basis of the market- based financial system. The negation of the
states regulatory role without creating a global watchdog has created a non-transparent and
unaccountable financial system that was pivotal in causing the crisis. Against the backdrop
of the collapse of previously high-flying financial institutions, which were considered too
big to be allowed to fail, states had to step in and rescue them pumping in billions of dollars
from the public exchequer. The result of the subprime crisis seems to be the classic
combination of capitalised profits and socialised losses. Capitalism cannot be blamed for the
crisis because it was not at fault; rather the absence of proper monitoring and regulations
can be largely blamed for this. Too much reliance on market force helped to cause the crisis.
The implications for the policy makers are that proper regulatory governance is essential to
ensure sustainability of the global economic and business activities. The perception that the
state has no significant role in market economy has been proved a myth. The state
intervention can be an important policy measure to restrain corporate excess, introduce
ethical and responsive corporate behaviour with a view to protecting stakeholders interest.
The crisis has also impacted the psychology of risk of the financial institutions. The
financial crisis and collapse (or near collapse) of many financial institutions triggered an
increase in the risk aversion of banking and financial institutions resulting in pulling back
them from lending. It has also dented the confidence of bank depositors who are concerned
about banks solvency. This increase in risk aversion will definitely have far reaching
ramifications on the access to finance, industrial output, trade and business transactions,
employment, discretionary spending and GDP growth of the countries across the world.


14

15








Appendix

Figure 1: Credit policy, asset prices (boom and bust) and financial crisis
relationship







Credit
Expansion
Asset
price
bubble
Madness in
lenders
attitude-
(more
credit)
Inflation
Loan default
(Banking/financ
ial crisis)
Asset price
bust/collap
se

Tightened
monetary
policy/incr
ease
interest
(credit
contractio
n)

(Source: the Authors)


16


















i
The high level of global liquidity stems from countries (such as China) current account
surpluses and foreign exchange reserves, maintaining artificially low exchange rates and a
positive savings investment balance.
ii
J ohn Edwards, Capitalism, The Deal, P-32
iii
Not only lenders but also Investors bought AAA-rated instruments with little or no further
diligence or consideration of risk
iv
Because low-doc loans involve higher risk, the lenders require a higher deposit from the
homebuyers, usually between 20 per cent and 40 per cent of the property's value
v
Mortgage lending on the basis of asset value, without regard to borrower ability to pay, is
widely recognized as predatory and harmful to borrowers.
vi
There were no data on the long term performance of home prices neither for the US nor for
any other country.
vii
In Finland, housing price rose by a total 68 percent in 1987-88 due to massive credit
expansion (bank loan to GDP ratio increased from 55 percent in 1984 to 90 percent in 1990)
17

18


viii
In February 2007 HSBC acknowledged a loss of $10.8 billion in its US real estate
portfolio. In J uly 2007, two of Bear Stearns hedge funds defaulted on about $10 billion of
financial obligations, causing losses of $1.5 billion of investors money. By August 2007,
there was large scale panic in the financial markets resulting in flight from the US real estate
market. Banks were no longer willing to provide liquidity to other banks since it was not
clear which financial institution was holding what quantity of toxic subprime mortgages
(Baaquie,2009). In addition to that, fear also acts as an obstacle which made banks reluctant
to lend (Andrews,2009)
ix
These are new developments in the financial system such as the growing use by banks of
the originate and lending model, the reliance on off-balance sheet vehicles, the development
of new structured products, and the reliance on ratings agencies in making them pretty to
investors (White,2008)
x
Bicksler (2008) referring to survey information observes that residential mortgage
borrowers were borrowing rate and transaction costs uninformed.
























19


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