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 The minimum short-term interest rate

charged by commercial banks to their "best“,


most creditworthy clients.
 The most favorable interest rate charged by
lenders on a loan to qualified customers.
 Lending to borrowers with highly rated credit
histories.
 Prime loans are often called "A-paper"
credits. 
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 The Federal Reserve Board increases the
prime rate during periods when the economy
is growing too fast to discourage inflation, and
lowers it when the economy is too sluggish to
stimulate growth. 
 The prime rate is the economic indicator used
by most credit card companies to determine
the interest rate charged on their variable
rate credit cards (as opposed to fixed rate
credit cards). 
 If Prime lending rate rise by .25%, new credit
card interest rate would increase to 8.00%.  If
the prime rate was lowered by .25, then
interest rate should fall back to 7.75%. 
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 "Sub prime" is any loan that does not meet
"prime" guidelines.
 Subprime lending (also known as B-paper,
near-prime, non-prime, or second chance
lending) generally refers to lending at a
higher expectation of risk than that of A-
paper.
 A subprime loan is offered at a rate higher
than A-paper loans due to the increased risk.
 A subprime loan may have less room for
financial difficulties of the borrower, which
can lead to late payments and defaults.
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A legal document specifying a
certain amount of money to
purchase a home at a certain
interest rate, using the property as
collateral.

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During the late 1990s and early 2000, interest rates fell
dramatically because of excess liquidity.

Prices of homes rose sharply.

They obtained liquidity at very high prices of homes but at


the interest rates that were at their lowest in the last 20
years.

This became a vicious cycle leading to a very sharp rise in


consumer spending and leading to global growth. This, in
turn, led to an increase in inflation.
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Inflationary pressures led to a gradual hike in
interest rates.

As a result, the cycle of taking loans to spend on


consumer items practically stopped and the
demand for homes started slowing down.

House prices went down and Americans are faced


with unemployment, decrease in consumer
spending, and dangers of economic slowdown.

Many borrowers won’t be able to repay the loans and


it forced most of the US banks to write off their
loans as bad.
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Unit:Billion Dollars

Merrill Lynch $22.4


Citigroup 19.9
UBS 14.4
Morgan Stanley 9.4
HSBC 7.5
Credit Agricole 3.6
Deutsche Bank 3.2
Bank of America 3.0
CIBC 3.0
Wachovia 2.7
AIG 2.7
Barclays 2.7
Royal Bank of Scotland 2.5
Credit Suisse 1.9
Bear Stearns 1.9
JP Morgan Chase 1.4
Countrywide 1.0
Others 4.6

Total $107.8

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Many institutions offered home loans to borrowers
with poor or no credit histories by requiring higher
than normal repayment levels — creating what is
now referred to as “sub-prime mortgages”

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On June 30, 2004, the Federal Reserve began a
cycle of interest rate hikes that raised the
interest rates seventeen times and paused only
in June 2006.

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Several sub-prime mortgage holders defaulted
on their loans and the first sign of a “crisis”
emerged in March 2007 when shares in New
Century Financial, one of the largest sub-prime
lenders in the US and more than 100 subprime
mortgage lenders filed for bankruptcy.
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The subprime lending was 9% in 1996 but in 2004 it
is 21%. So many sub prime loans are in default.
Major banks and other financial institutions
around the world have reported losses of
approximately US$435 billion as of 17 July 2008.
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 Loan modification, pumping money into
market may slow down the crisis.
 Pumping money into markets, reducing
bank reserves may temporarily weaken the
crisis. But this is a two fold operation:-
3) Pumping money will increase inflation which
will results in increase in subprime lending.
4) Reducing bank reserves to small extent is
better but as whole it would destabilize the
whole financial system
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