Subprime Meltdown

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Subprime Meltdown: American Housing and Global Financial Turmoil Borrowers with a lower credit score were considered as risky and were called ‘subprime borrowers’. Therefore the interest rates on these loans were higher than the rates given to borrowers with a higher credit rating. In the 1970s it was very difficult for these borrowers to avail loans. They had to apply through conventional lenders for loans insured by the Federal Housing Administration (FHA). The procedure was long and tedious and required a lot of documentation. Early Days: Lenders traditionally offered the fixed 30-year mortgage with no prepayment penalties which were offered by the banks and Savings and Loan Associations (S&Ls) However in the 80s short term interest rates shot up, which meant that the yield on these mortgages fell below the rates paid to depositors. As a result most of the S&Ls failed. This led to the securitization of these mortgages by two Government Sponsored Agencies named Fannie Mae and Freddie Mac. Innovations: These new entrants also started offering innovative loans to the borrowers and the mortgage brokers indulged in a lot of mis-selling. As a result borrowers did not understand what they were getting into and they were stuck with loans not suited to their repayment capacity. New and popular mortgages were now being sold by the brokers. The 2/28 mortgage was one such example, where the borrower paid a fixed rate for the first 2 years and a variable rate for the next 28 years. Adjusted Rate Mortgages (ARMs) allowed the borrowers to choose the interest rates payable initially. Teaser loans also became popular as they were considered to be very ‘cheap’ in the initial years, but the rates shot up in the latter years. Over a period of time this slicing and dicing of the mortgages created a mess which people did not understand. The risk associated with them was not assessed properly by financial intermediaries. Most of the participants followed the trend instead...
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