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US Financial Crisis Began with Subprime Mortgages


As officials and business leaders struggle to rescue the U.S. economy, the news has been filled with strange terms like "mortgage-backed securities" and "leverage." Most people know that a mortgage is a home loan. Lenders add a charge called "interest" to the mortgage amount and borrowers repay the loan, plus interest, in monthly payments over many years. But many are baffled by the newer terms. VOA's Jim Randle translates some of the Wall Street-speak into more understandable language.

The financial crisis started because people like Darnell Horton, who bought a home near Atlanta in the southern U.S. state of Georgia, could no longer afford to make payments on their subprime mortgage loans.

Subprime is a term that refers to risky loans that initially had low interest rates but after a few years, the interest rates jumped. Also, these loans required less verification: like whether borrowers had jobs.

As long as home prices were rising, borrowers who had difficulty repaying loans could sell their houses at a profit and pay off the loan. But when home prices fell, homeowners with financial problems lost their homes in foreclosures. Banks and other lending institutions lost revenue.

The impact was magnified by "mortgage-backed securities."

George Mason University Professor Gerald Hanweck says these were created by companies that bought mortgages from lenders.

"A mortgage-backed security is basically a bundling of individual mortgages, maybe upwards of 1,000 maybe 1,500 in one entity," Hanweck explains.

Investment firms not only bought bundles of risky subprime mortgages as mortgage-backed securities, they also borrowed money to buy some of these bad debts. The use of borrowed money to make investments is called "leverage," but it's also risky.

"You can amplify your return on that investment," University of Maryland Professor Elinda Kiss said. "But you can also amplify your loss."

When mortgages went sour, some highly leveraged (deeply indebted) corporations went bankrupt. Some of them like Lehman Brothers were huge companies that played a major role in the global economy. Their collapse frightened investors and sparked a steep decline on stock exchanges worldwide.

Many banks and other lenders stopped offering loans because they thought they might not be repaid.

Professor Kiss says without credit, business slows down and some companies have to lay off workers. Those workers reduce their spending, and that hurts other businesses.

"They are not going to go to restaurants, they are not going to buy new clothes, those stores lose business, [then] they have to lay off workers and it spreads throughout the economy," Kiss notes.

In the end, the economy stalls.

Advocates of the government bailout say the plan to buy up bad mortgage-backed securities will restore confidence, spur lending, and get the economy growing again. But others question whether that will motivate the average American to start buying again and stimulate the economy.

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