Subprime Crisis: Cause, Effect and Response

Abstract

After the dot-com bust, the U.S. experienced growth in the housing industry: oversupply of capital, low-interest rates, and deregulated financial system. Financial firms, led by banks, rode on a robust macroeconomic atmosphere. The freedom brought by financial deregulation was taken out of context among the firms in the financial system, resulting in the establishment and widespread use of collateralized debt obligations (CDOs) and mortgage-backed securities (MBS) (CDO); these were unconventional investments for the general populace. In retrospect, the U.S. government limited banks’ participation in private-labeled asset-backed securities to tame interest rates, liquidity, and credit risks only to be loosened the following years by Congress through amendments to the existing laws. Deregulation of the banking system encouraged banks and thrift banks to engage in real estate businesses, which paved the way for the rise of the subprime market. The subprime market grew alongside the prime market due to banks’ circumvention of borrowers' creditworthiness. The domino effect began from the failure of the subprime borrowers to repay. Vertically integrated banking giants felt the heavy blow of loan default, which caused their insolvency. Since then, the whole financial system has collapsed entirely. An increase in job losses, a rise in homelessness, business closures, and U.S. negative growth ensued. Through the TARP program, the Dodd-Frank Wall Street Reform and Consumer Protection Act, and quantitative easing.