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Subprime Mortgage Crisis

Subprime Mortgage Crisis

Who is responsible for the subprime mortgage crisis? Could it have been prevented? This article takes a look at some of these questions.
Rahul Pandita
A subprime mortgage is provided to those people who have a poor credit rating and are not entitled for conventional mortgage loans. They are also known as interest-only loans as for the first several years, one only needs to make payments on the interest. After a few years, the principal and the interest are combined which increases the monthly payments. The people who took these loans had hoped that before the monthly payment increased, they would be able to refinance their homes to a lower rate of interest. But most of them were not able to do so and the housing bubble burst, plummeting the US economy into the worst ever recession since the Great Depression of 1929.

If we have to fully understand the causes, we will have to look back to the beginning of the new millennium. The timeline starts from 2001 when all of a sudden, all the big investment firms were concerned about where to invest their surplus capital. The criteria of obtaining a mortgage loan those days was pretty strict. If you had a well-paying job, good credit score, enough collateral, etc., you were eligible for a loan, but if you lacked any of these, the chances of getting a mortgage loan were pretty low. But then, a home was always and still is an important part of the great American dream. This is where the investment firms stepped in. Mortgage-backed securities became the buzzword for investors and the process of getting a home loan became easier. There was a time when everyone qualified for one. The transaction proceeded this way. An individual used to get a subprime loan from a broker, who in turn sold it to a bank. The bank then sold the mortgage to the investment firms on Wall Street. These firms bought the loans as the returns were fairly high and the profits could be shared among investors to encourage them to pump in more money.

Downturn in the Real Estate Market

Until late 2005, everything was going according to the way the investment firms had planned it to happen, but in 2006, the high interest rates on traditional loans led to a fall in overall demand, and therefore, the housing prices. This depreciated the value of many homes in the US and people were not left with enough equity to pay off their loans. As mentioned before, one of the reasons people opted for subprime loans was, because they thought that with time, their homes would appreciate and refinancing will not only help them get lower interest rate loans, but would leave enough money to pay off other expenses like credit card bills, remodeling of the home, etc. Falling prices left close to about 23% of the US homes to depreciate. As the borrowers were not able to pay back, the lenders had to initiate a huge number of foreclosures.

Full-Blown Crisis

The foreclosure of the homes led to an over-supply in the market with little or no buyers. This is when the issue turned into a full-blown crisis. The investment firms who had financed these mortgages, had invested their money in hedge funds, but after the collapse of the real estate market, these funds became worthless. It meant that the lenders too had to file for bankruptcy proceedings. The crisis along with an unstable stock market, failed hedge funds, and some other global factors contributed majorly to the Wall Street collapse and the subsequent economic recession in 2008.