Question

The combination of falling U.S. housing prices and the large number of subprime borrowers defaulting on their mortgages just prior to the financial crisis of 2008 created a solvency problem for U.S. commercial banks that had provided mortgage loans to subprime borrowers and held those mortgages on their balance sheets (ie. they did not sell them to Special Purpose Vehicles). Briefly explain how these two events could threaten to make those U.S commercial banks insolvent.

Answer 1

                                    The fall in housing prices and the subprime borrower defaults have great impacts on the commercial banks. The above situation clearly defines the fact that those were the major factors that led to the financial crisis of 2008 and its impacts on the US economy, especially the commercial banking sector were disastrous. Now let us analyse how these two factors affects the solvency of commercial banks in general and the US in particular.

                                    With the fall in the housing prices, the cases of home loan defaults are expected to increase on a large scale resulting in the lose of wealth for the banking sector. The home equity is also expected to dry up during this time resulting in lower spending, saving and investing capabilities of the public which would have prudent effects on the banks. The fact has to be kept in mind that it was the precipitating factor that lead to the financial crisis of 2008 which had profound impacts in the US too. With the fall in housing prices from 2006, the subprime borrowers also increased on a large. With the housing prices which further saw a huge fall, the effects began to spread which also resulted in the non repayment of subprime mortgaged loans.

                                    The federal government, since the great depression of 1930’s had focus on lending mortgage loans on a large scale since they believed that it was important for the economy to have homeownership to many of the middle class. Between 1940 and 1970, the home ownership almost doubled. The US economy believed that home ownership will lead to better earnings for the people which would strengthen the economy in return. Thus mortgage loans were approved in plenty. With the advent of 21st century, the Private Label Securities market began expanding, which lead to the fall of mortgage market of the government sector. When the economics trends began to reverse, the consumers were exposed to complex products and functionalities and became unaffordable to repay. With minimal government regulations, the housing market were stalled at once which lead to a deeper crisis in 2008. The failure of the PLS market, rise of predatory lending and misinformation on the products and features enhanced the crisis. The banks also began to sell many mortgages to feed the demand for mortgage backed securities, which lead to the subprime mortgage crisis. When home prices fell in 2006, it lead to defaults, which spread to the mutual funds market and finally resulted in banking crisis which lead to the financial crisis on a global scale and US in particular suffered huge loses, especially the commercial banks. Thus the banks became insolvent since all the measures they took prior to the crisis proved disastrous.