The current credit crisis, which began in August 2007, mainly revolves around one aspect of the mortgage business: subprime loans. Subprime loans are loans made to borrowers with less-than-perfect credit. They are usually priced higher than prime loans due to the greater risk of default by the borrower. Many of these loans were made during the recent housing boom when real estate prices were rapidly growing. During this housing boom, it also became increasingly easy for people to obtain loans due to the transformation of the mortgage business from a localized operation, centered on banks, to a global one, in which investors from around the world could pool money to lend. The process started with a borrower getting a mortgage from a bank to buy a house that he or she could not afford. The bank then divided and bundled the mortgage into a security, which was sold to investors. Despite their high returns, these securities also carry a high risk of default, after which they become worthless. Investors who over-committed their portfolios to securities backed by sub-prime mortgages - especially those who leveraged their investments with credit - exposed themselves to massive losses, which have been realized during the recent credit crises.
Housing prices, which peaked in early 2005, began declining in 2006, leading to an increase in foreclosure rates in 2006 and 2007, as the valuations of homes decreased while mortgage payments stayed the same. Banks, many of which had also sold complex insurance policies to cover mortgage debt for other lenders, retained responsibility when people could no longer pay their mortgages. Investors who had a high stake in these banks saw devastating losses as borrowers began to default at an alarming rate.
The collapse experienced by a few investment banks, such as Bear Stearns, caused widespread panic in the market, making banks reluctant to loan money and investors hesitant to purchase mortgage-backed securities. Many economists have said the only solution is for the federal government to intervene and buy some of the unwanted debt, as the Federal Reserve has begun doing. The government bailouts are part of a greater move to restore market confidence, as analysts claim that an increasing trend toward conservatism is leading the American economy into a recession.
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