The world’s only remaining superpower is at risk of an economic collapse because of the subprime mortgage crisis, but many people are confused as the why this happens in the United States.

Many wonder why the government never anticipated the problem, and why does it need to bailout the failing financial institution. Here is a detailed timeline on how interest rates and real estate play an integral role in the United States economy, as well as those who are suffering from this crisis.

Downturn in real estate

In December 2006, economic experts have noticed that the real estate market suffered from low new home permits, which are issued about six month before the new home is completed and the mortgage closes.

Real estate is a leading indicator of the US economy, because a decline in real estate could decrease construction jobs, thus increasing unemployment. Meanwhile, a decline in new home closings reduces home equity loans, which reduces consumer spending.

Decline in real estate spreads to the subprime mortgage

A subprime mortgage is granted to borrowers whose credit history is not sufficient to get a conventional mortgage. Many homeowners took such subprime mortgages such as interest-only loans because they are being marketed as cheaper to pay, but in reality they are merely paying the interest of their loans.

Through these loans, many people afforded to buy high-priced housing properties, hoping they would sell it at an even higher price in the future. Problem is, with a downturn in real estate these homeowners end up living in homes that are lower than what were worth and cannot even pay the loans they have borrowed, so they default.

The banking industry undergoes liquidity crisis

In August 2007, banks stopped lending to each other because they were cautious of getting caught with bad subprime mortgages caused by so many defaults. The United States’ central bank, called Federal Reserve, stepped in to restore liquidity and public confidence by spending hundreds and billions of dollars to guarantee or buy-back subprime mortgage-backed securities.

Mortgage crisis spreads to other debt packages

In October 2007, other debt packages such as collateralized debt obligations (or CDOs) became at risk of liquidation.

Investors who bought sophisticated credits products like CDOs were too happy to pay whatever the seller asked. However, CDOs are so complex that investors would have a hard time determining the real value and price should be. And as the subprime mortgage crisis hit, investors began to doubt the sellers.

The $75 billion superfund

In November 2007, three banks-Citigroup, JPMorgan Chase, and Bank of America-hired Blackrock Investments to run a $75 billion "superfund" to address the liquidity crisis. It is intended to buy distressed portfolios of defunct subprime mortgages.

Fed Funds rate lowered slightly

In December 2007, the United States government, particularly the Federal Open Market Committee, lowered the Fed Funds rate by ¼ point to 4.25% as well as its discount rate by ¼ point as well. The Fed Funds rate directly influences short-term interest rates like bank deposits, bank loans, credit card interest rates, and adjustable-rate mortgages.

This increased inflation in imports, such as oil prices, while keeping adjustable-rate mortgages affordable. This caused the stock market to drop 294 points in disappointment because the Federal Reserve did not react more aggressively by dropping the discount rate by ½ point.

Federal Reserve auctions $40 billion in loans

In an effort to rescue ailing banks that cannot get loans from other banks, the Federal Reserve has auctioned $40 billion in short-term credit in December 2007.  Since it was unknown at the time which bank was suffering from bad debt, and how much is out there, banks have become afraid to lend to each other because no one wants to end their year with debt. 

Federal Reserve tries to loan $200 billion in Treasury notes

In March 2008, the Federal Reserved attempted to loan $200 billion worth of Treasury notes to bail out bond dealers who are stuck with mortgage-backed securities and other collateralized debt obligations that they cannot resell on a secondary market.  The reason is because the secondary market has dried up as a result of the subprime mortgage crisis.  Again, no one knows who has bad debt, and how much is out there, so all buyers of debt instruments have become afraid to buy and sell from each other. 

Federal Reserve bails out Bear Stearns

Days after the announcement by the Federal Reserve about loaning Treasury notes, the banking industry has witnessed its first casualty in Bear Stearns, which was in danger of going bankrupt because of bad mortgage-backed securities and other collateralized debt obligations.  Bear Stearns was worth $3.5 billion after it has announced that it was to be bought by JP Morgan Chase, which was necessary after Moody’s downgraded its subprime mortgage debt.  However, JP Morgan Chase realized that Bear Stearns was only worth $236 million-1/5 the value of its headquarter building.  In other words, Bear Stearns is completely worthless.  The Federal Reserve stepped in and lowered the primary credit rate to 3.25% in an attempt to liquefy financial markets.

Fannie Mae, Freddie Mac, and other regional banks absorb $300 billion in bad debt

The Federal Housing Finance Board agreed to let regional Federal Home Loan Banks take an extra $100 billion worth of mortgage-backed securities for the next two years.  These loans must have been guaranteed by Federal National Mortgage Association and Federal Home Loan Mortgage Corporation (more popularly known as Fannie Mae and Freddie Mac respectively), who were allowed to take on an additional $200 billion in subprime mortgage debt.  By this time, a total of $730 billion in subprime mortgages has been guaranteed by the Federal government.

Federal Reserve auctions reaches a total of over $1 trillion

Over the next three months, the Federal Reserve had auctioned a total of $475 billion to the financial market through its Term Auction Facility.  It may be seen that the banks and other financial institutions may have a lot of subprime mortgage debt in their books.  This brings to a total of $1.2 trillion that the Federal government has pumped into the financial markets.