Over the years one of the most admired features of the US economy is the ability of its citizen to acquire and purchase their own homes. This was made possible by affordable mortgages, a hallmark of the Franklyn Roosevelt New Deal Policy. Home ownership not only contributed to increasing equity a compliment to US household income but has been a driving force in the country’s economic activity for decades. However, an economy with one of the most commendable mortgage policy has now being rocked by a crisis of unforeseeable magnitude as manifested by the recent US Sub Prime Crisis. The Sub Prime Crisis has been cutting slowly but deeply into the US economy despite global efforts to ensure a soft landing.

Understanding the crisis and its implication even though at an early stage is what this article attempt to address.

When the Sub Prime rate first erupted in 2006 few would have predicted that a portfolio of US$34 billion would eventually threaten a $57 trillion strong US financial system. More over, Sub Prime lending was considered the bottom end of the mortgage market and any system risk from such a crisis was considered manageable. However, when the core mortgage institutions such as Fannie Mae and Freddie Mac faced imminent crisis last week the alarm bell rang loudly. The stock markets around the world reacted by hitting its lowest ebb in more than four decades. Consumer confidence was at an all time low and investors extremely nervous.

Historically, the late 1930’s saw US mortgage financing consisted mainly of deposit taking institutions such as banks, saving and loan groups that collected deposits to fund home loans. The cost of these mortgages was high and mainly short term lending. The institution carries) the credit, market and liquidity risks. In an effort to ease these risks President Roosevelt’s New Deal policy created the Federal National Mortgage Association (Fannie Mae) in 1938. Fannie Mae started as a government owned corporation to develop a secondary market in mortgages. It was thus better able to handle the financial risks and provide long term funds for lending that conform to that of prime mortgages.

After being financially successful the government eventually privatizes Fannie Mae in an effort to move it off the federal budget. The Federal National Mortgage Corporation (Freddie Mac) was created in the 1970 to provide competition to Fannie Mae. Freddie provided securitization to conventional mortgage and broadens the mortgage base to lower income group. These two institutions not only provided affordable finance for mortgage but helped to broaden and deepen the US Financial system with an efficient and effective secondary market. Currently, these two government sponsored institutions hold or guarantee $5,200 Bn in mortgage debt (Financial Times 14/07/08).

The innovations in the US Financial Markets had led to new products and instrument to satisfy the housing needs of the population at different levels of income. One such product is the Sub Prime Mortgage Rate that provided financing mainly to the lower level income earners. Riff and Mills (2007) in a research paper entitled “checks for free, money for nothing define Sub Prime Mortgages as residential loans that do not conform to the criteria for “prime” mortgage and so have a lower than expected probability of full repayment. They argued that such assessment is made according to the barrowers’ credit record and score such as, Debt Service to Income (DTI) ratio and or the mortgage Loan to Value (LTV) ratio. Barrowers with low credit scores LTV above 55% and or LTV over 85% are likely to be considered subprime clients.

The financial product called securitization that I alluded to earlier has allowed for the sub prime risks such as credit, asset price, liquidity and counter party risk to be passed to third party investors via Mortgage Backed Securities (MBS) and Collateralized Debt Obligation (CDO). These instruments allowed for more favorable Sub Prime rates that allowed increased home ownership as demand for housing grew. Overall US home ownership increased from 64% in 1994 to 69.2%) in 2004. The increased demand and easy credit helped fuelled housing prices and consumer spending. In the decade to year 2006, home prices increased by 124% inflated by Sub Prime Lending.

However, a combination of adverse economic factors forced the bursting of the housing bubble early 2007.

The value of US Sub Prime mortgage was estimated at US$1.3 trillion in 2007 with approximately 16% of the loans in the Adjustable Rate Mortgage (ARM) categories being 90 days delinquent and facing foreclosure.

This figure rose to 25% by May, 2008 and continues to climb with the bursting of the bubble. Currently, house prices continue to fall and investors accumulating inventory leading to an oversaturation of the housing market.

The Economist (07/18/08) stated the Fannie and Freddie invested heavily buying 50% of all mortgage back securities that left them very exposed to Sub Prime liability. It further stated that the two groups had core capital of US$83.2 billion at the end of 2007 supporting $5.2 trillion of debt with guarantees ratio of 65 to one along with counter parties of US$2.3 trillion worth of derivatives and hedging transactions. Here is where Fannie and Freddie had to take the write down on their profits and despite their core prime lending being in tact.

The US Treasury hurriedly put together a very generous rescue package to ensure the survival of Fannie and Freddie. After some turbulence, it has helped to calm capital markets around the world. However the financial system is not yet out of the woods and situation remains volatile with corrections still taking place. The important lesson is a financial system however developed is subjected to distortion and disturbance. The crisis once again brings to bear the weakness on the international financial system in early detection of financial problems. Secondly, like the Enron crises when accounting standards came into question, this crisis exposed the limitations of rating agencies and the regulatory frame work. Bonds that were rated triple A+ were down grades overnight to B”. Regulatory agencies will have to be more equipped to make better evaluation to build investors confidence.

The contagion effect of the US Sub Prime crisis is now being felt by countries that are tied to the US financial markets but a realistic assessment can only be made after the dust has settled. A positive feature that despite being exposed to the US financial markets the countries of Latin America and Caribbean have not being seriously affected by the crises. This is an indication that these countries have developed far more resilience to financial down turn when compared to some developed countries