Question

Discuss the main factors which led to the outbreak of the 2007-2009 Sub-Prime Mortgage Crisis in the US? Given the example about the Sub-prime crisis and Northern Rock, Please answer the following questions: What are the origins of the sub-prime crisis? How did this crisis impact on Northern Rock? What role did the Repo and the Inter-bank markets play in the crisis? How did the Government and the Bank of England act to save Northern Rock?

Answer 1

The sub-Prime mortgage crisis was not a bubble that had formed in a year so but it was building up after the dot com crash of 2000. The economy struggled and thus to lend a lifeline the federal reserve reduced the rates thus making the subprime loans cheaper. This helped the americans to get hands on those properties which were not affordable earlier. In due course of time with increasing housing prices the subprime loans also started rising exponentially and thus to control this the federal reserve tried increasing the interest rates. With the increasing interest rates the subprime lenders instead of filing for bankruptcy, they started laying off people and didnt stopped giving out the loans.

The bubble was creating and was far bigger than anyone could have imagined.The subprime lenders were selling these off to the investment banks as mortgage backed securities which were further sold in bundles due to which the same subprime lender got money for more lending. Eventually the bubble burst as the lenders were no longer able to pay the interest which eventually got higher. This led to a chain effect which engulfed the major investment banks in USA namely Lehman Brothers. which led to the involvement of the US federal reserve.

The Northern Rock was a bank in England which followed the orthord ox banking model. They allowed in the deposits and thus used this money for mortgages. The bank relied upon the wholesale international markets for the funding in a way in order to bring in liquidity the bank had to sell the bonds every 3 months in the market.The bank had a lot of exposure to the markets being its major source the bank eventually did not fell due to the credit crunch caused in the world but was responsible for the credit availaibility of the credit not able to honour their commitments.

The main reason was the securitization. The bank had been resorting to buy the long term bonds by leveraging the balance sheet. That is the short term borrowings were being used to fund the long term ones and thus the bank was borrowing for various banks. This is where the repos come in place where there is usually a haircut ie if a bank wants to borrow form other banks they had to pay a price ie they can borrow 100 for 98 which means a 2 percent haircut. As the leverage increases in the balance sheet even a small change would further become costly to raise money through the repos which eventuall made for the bank to raise money through repos due to which they had to resort to raising equity shares or selling off the assets which was not possible in the distressed market.

Thus when it went bust the Bank of England had to bailout the bank withe the taxpayers money which eventually costed 3 bilion euros. In the year 2010 the bank was eventually sold out to the private by splitting into two parts ie assets and bank.