Anatomy of a Meltdown: The Subprime Crisis

At the close of 2007, the bloated inventories and declining prices of residential housing confirmed that the real-estate bubble had burst.  This was triggered by losses on collateralized mortgage obligations (CMOs), which are based on pools of “subprime” mortgage collateral.  Residential prices have not yet fallen below the levels of 2001 (when the bubble began) and, for the moment, remain above recession-level prices.  The meltdown, however, is on.

Over the last several years, our soaring trade deficits have filled our foreign competitors’ coffers, causing them to seek investments that are more attractive than U.S. Treasury bills.  Because the large commercial investment properties they prefer have been priced very high, U.S. financiers began selling them the derivatives of residential mortgages pools.  The adjustable-rate mortgage (ARM) pools offer investors the largest source of inflation-adjustable securities, along with the protection of insurance against default and the prospect of higher average interest rates over the life of the securities.

Ever since the Great Depression, Congress has created federal agencies that accept or insure mortgages.  Government-sponsored agencies multiplied after World War II, as insurance providers for the home mortgages of returning veterans.  Savings and loans, also sponsored by Washington, were the principal investors in these insured...

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