The Subprime Crisis: Cause, Effect and Consequences

Abstract

Despite the considerable media attention given to the collapse of the market for complex structured assets that contain subprime mortgages, there has been too little discussion of why this crisis occurred. The Subprime Crisis: Cause, Effect and Consequences argues that three basic issues are at the root of the problem, the first of which is an odious public policy partnership, spawned in Washington and comprising hundreds of companies, associations and government agencies, to enhance the availability of affordable housing via the use of creative financing techniques. Second, federal regulators have actively encouraged the rapid growth of over-the-counter (OTC) derivatives and securities by all types of financial institutions. And third, also bearing blame for the subprime crisis is the related embrace by the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board of fair value accounting. After reviewing the Bush administration's proposed solutions as flawed, this article recommends a strategy for subprime crisis resolution. Job one is to rebuild market confidence in structured assets by going back to first principles on issues such as market transparency, standardization of contracts, and accounting treatment. By reducing complexity on the trade of structured assets through simple deal structures and providing investors with the information they need to analyze collateral, for example by requiring SEC registration and public pricing of assets, much of the current liquidity problem is ameliorated.

Keywords: Subprime crisis, affordable housing OTC derivatives, fair value accounting, structured assets