Economic Effects of Sub-Prime Loans

Topics: Subprime mortgage crisis, Debt, Mortgage Pages: 5 (1462 words) Published: September 21, 2013
Economic effects of subprime lending
A subprime lending is an option for individuals that have difficulty meeting mortgage payment schedules or for individuals who have low credit scores and considered risky borrowers. For example, an applicant with a low credit score of 500 will have a very difficult time locating a loan. Subprime lending comes with a high cost to borrowers. Lenders see bad credit applicants as riskier than applicants with better credit scores. Borrowers in turn pay for this risk by accepting loans with a higher interest rate. Subprime lenders offered the realization of the American dream of home ownership to borrowers who would otherwise be denied credit. Interest only loan options were offered, and combined with the mortgage-backed securities (MBS) added so much liquidity that in turn created a housing boom. Over time borrowers end up paying higher interest rates with zero payment application against their loan amount. Unemployment setbacks that ultimately resulted in defaults, added to the economic crisis. Consequently, more homes were placed in a market that is already saturated with newly constructed homes. This created less demand resulting to more houses that builders were unable to sell.

Controls of banking rules and regulations during the 1980’s were relaxed, and monitoring policies for these were not the highest priority. Jimmy Carter’s “Depository Institutions Deregulation and Monetary Control Act of 1980” was a window for financial institutions to continue their momentum of relaxed lending practices. Yet another regulatory policy under the “Gramm-Leach-Bliley Act of 1999” was passed that removed barriers between banks and mortgage investment lenders. This regulation was viewed as pivotal to the economic crisis as it allowed commercial banks, investment groups, security companies and insurance groups to merge and package an all in one type service to the mortgage borrowers. Thus, companies like Citigroup and J.P. Morgan Chase came into existence helping create a string of bank failures. New borrowers started signing up for sub-prime deals that were in reality financial traps as they were lured into higher rates. Subprime lending became popular targeting those with difficulties in managing their mortgage payments and those with weak credit histories. Eventually, the economy was unable to control the rise of mortgage delinquencies and foreclosures. Foreclosure rate began to climb in 2006. According to the Mortgage Bankers Association, the number of foreclosures reached a record high of more than 900,000 households, or 71 percent from 2007. Ultimately, subprime borrowers found themselves swimming uphill unable to refinance due to increases in their loan to market value ratios caused by the falling home prices. Consequences of poor stewardship and lack of social responsibility

In the New York Times issue on “ Financial crisis was avoidable” (Chan, 2011), it was argued that the 2008 crisis was an avoidable disaster had the decision makers exercised better stewardship in implementing government regulations, corporate management and calculated risk-taking decisions.

The government policy makers who were instrumental in the passage of the Gramm-Leach-Bliley failed to implement a sustainable framework that would have monitored and controlled the pandemonium of risky mortgage lending.

Two administrations of Federal Reserve leadership were characterized as an example of negligence that caused the escalation of subprime lending and the expansion of the housing bubble. Federal Reserve Chairman Alan Greenspan and his successor Ben Bernanke were supposed to be the “watch dogs” but instead permitted this crisis to occur amidst shoddy investor mortgage lending, excessive packaging and sale of loans to investors and risky bets on securities backed by the loans.

The bankers were also accused of greed as they pushed for marketing the subprime lending to investors and ultimately to...

References: Caldwell, C., Hayes, L., & Long, D. (2010). Leadership, Trustworthiness, and Ethical Stewardship. Journal of Business Ethics (2010). DOI: 10.1007/s10551-010-0489-y
Gilbert, J
Murphy, E. (2009). The relevance of responsibility to ethical business decisions. Journal of Business Ethics (2009). DOI: 10.1007/s10551-010-0378-4
Thiel, C., Harkreiderr, L., & Mumford, M
Leonhardt, D. (2008). The Invisible Hand. New York Times. Published September 26, 2008. www.nytimes.com/2011/01/26/business/economy/26inquiry.html
Chan, S
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