Microsoft Word Thesis Gent (1). doc

Figure 2. US House price trend 
Percentage increase/decrease year-over-year (yoy) 
Source: Center for Responsible Lending 

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14 
The beginning of the credit crisis in 2007 occurs from the sub-prime mortgage markets 
in US. As financial institutions provided loans to diverse credit risk ratings (not only 
AAA), among which were some very risky loans, the prices of housing continued to 
increase as the demand increased. As the loans were provided to risky credit ratings, the 
sub-prime loans increased, thus the there was a creation of the house bubble down 
payments on mortgages that was increasing and it was difficult for debtors to repay 
their loans. The sub-prime loans have usually been issued at fixed interest rates; 
however since 2000 these loans were issued at adjustable rates.
Most of the time the adjustable rates meant that the sub-prime loans rate in the 
introductory period was about 1 percent, which is quite low. Consequently, when this 
period ended the monthly payment of these loans was significantly higher. The 
introductory period of a low rate at 1 percent attracted borrowers to take these loans, 
that in 2006 the loans that started with this percentage accounted at about 80 percent of 
all sub-prime loans. 
The monthly payment of these sub-prime loans differed from year to year, but a study 
showed that there would be a larger increase of the monthly payment of these 80 
percent loans by more than 25 percent since 2004 compared to the coming years. The 
higher monthly payments, besides regular payments, were also impacted by delinquent 
sub-prime loans or the loans that were in foreclosure by February 2008. With the rising 
number of sub-prime loans that were in foreclosure in 2008, the value of mortgage that 
was used as securities by investors and banks started to fall. A few important 
characteristics of sub-prime loans boost were that the investment banks used the 
security that is backed by mortgage, collateralized the debt obligations (CDOs), and in 
order to spread the risk of loans and free up capital for lending they used several 
complex financial instruments. Even though, the sub-prime loans were considered as 
risky and not accounted as investment-grade, the ability to make mortgages backed as 
security and collateralizing the debt obligation allowed banks to spread the loss from 
the loans that defaulted among many of them thus minimizing the loss for the investors. 

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15 
As the sub-prime loans were backed by security mortgage and were of higher risk, this 
meant that the returns were higher on prime-backed securities. The high risks made the 
investment on these loans popular and increased the interest of investors that included 
banks, hedge funds, and asset management firms. With the increasing amount of sub-
prime loans, the default loans and the loans in foreclosure increased, thus the value of 
securities that were backed by these loans decreased. This meant that the investors were 
facing larger losses and had to reallocate their capital from other investments to 
building capital in order to cover the losses of sub-prime related securities. As the 
losses increased from these securities, the capital of the financial service firms 
decreased for other means of usage. In the USA the companies of many industries tend 
to rely on these financial firms for money support through different loans, this support 
was decreased as these financial firms capital decreased. In this way, the companies of 
different industries could not keep growing, which impacted the whole economy.
This was as a chain of problems that started with issuing large number of sub-prime 
loans, then having large default loans, which required more capital by investors to 
cover the losses, that decreased the capital for other companies to be supported in their 
growth, thus created losses throughout the economy that led to crises. According the 
International Monetary Fund (IMF) results the total losses in US assets exceeds $4,000 
billion. Explanations of this crisis are many including government actions and 
interventions, which prolonged and made this financial crisis worst, (Taylor, 2008).