The U.S. subprime mortgage crisis was a set of events and conditions that led to a financial crisis and subsequent recession that began in 2008. It was characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages. These mortgage-backed securities and collateralized debt obligations initially offered attractive rates of return due to the higher interest rates on the mortgages; however, the lower credit quality ultimately caused massive defaults. Several major financial institutions collapsed in September 2008, with significant disruption in the flow of credit to businesses and consumers and the onset of a severe global recession.
By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak. This major and unexpected decline in house prices means that many borrowers have zero or negative equity in their homes, meaning their homes were worth less than their mortgages. As of March 2008, an estimated 8.8 million borrowers 10.8% of all homeowners had negative equity in their homes, a number that is believed to have risen to 12 million by November 2008. By September 2010, 23% of all U.S. homes were worth less than the mortgage loan.
Wall Street firms sought to connect the rich investors with the rapidly expanding housing market with the help of complicated financial instruments. These instruments such as mortgage-backed securities we've heard so much about made it easier to move the investors' funds into the housing market, which fed the extraordinary price spiral, Rodriguez said. "It began to really take on a life of its own when people saw how much money they could make in housing," he said. "Before long, everybody was pushing along the momentum of this train. “So how do these mortgage-backed securities work and what role did they play? Let's say there are three prospective homebuyers in a neighborhood. A local bank makes mortgage loans to all three, then bundles up the mortgages and sells the bundle to a big Wall Street firm, like the now-bankrupt Lehman Brothers. The Wall Street firm takes its bundles of mortgages and offers them to investors. The investors make money off the interest payments from the original borrowers. These instruments helped minimize risk for the local bank because it was no longer responsible for the loans it made to the local homebuyers. "You didn't even have to worry about a loan once you made it. You didn't have to keep it on your books," Rodriguez said. "The only limitation was how fast you could turn the loans. “It was an intoxicating era when you could make a lot of money quickly through the housing market, and you did it through the "basic idea of leverage," Rodriguez said. He provided an example: You take out a mortgage loan for $100,000 and make a 20 percent down payment, which would equal $20,000.If the price of the house goes up to $120,000, you've effectively doubled your money. If you sell at that price assuming there are no transaction costs you walk away with an extra $20,000.Leverage works the same way for banks. They borrow from other banks or other institutions so that they can hand out more loans and make more money. "This encourages all sorts of risky behavior by individuals looking to buy homes, and it encourages banks to lend because, in an environment where prices rise, they're making lots of money, too," Rodriguez said.
In financial economics, a liquidity crisis refers to an acute shortage of liquidity. Liquidity is a catch-all term that may refer to several different yet closely related concepts. Among other things, it may refer to market liquidity funding liquidity or accounting liquidity additionally, some economists define a market to be liquid if it can absorb "liquidity trades without large changes in price. This shortage of liquidity could reflect a fall in asset prices below their long run fundamental price,…