To understand the Subprime financial crisis which started in US in 2006 and has become a global problem in 2007 we need to look in to terms like Subprime lending, foreclosures, the US housing bubble, the causes behind such phenomenon, the role played by lenders, home owners, central banks and then the impact on corporations, investors, stock market and the US economy as a whole. The Subprime lending market started as a way of providing finance to those who had a bad credit history and were able to provide collateral like a house that could be used to guarantee the loan.
The loan was paid at rate higher than the normal ones due to the increased risk involved. Many of these mortgages were sold by unscrupulous and little regulated mortgage brokers, who received handsome commissions for selling expensive and unsuitable products. Some customers were not told that their interest rates would go up sharply after two years; others were promised they could refinance their home before higher rates took effect. Due to the falling prices of home created by the US housing bubble the amount of loan became more than the house itself leading to foreclosures.
For a borrower who wasn’t able to afford monthly payments and didn’t have the savings to refinance his house had to give up his house. Major Impacts The subprime industry has begun to implode as many credit-challenged borrowers fall behind. Subprime mortgages have grown so quickly and become so pervasive that their collapse could foster a multitude of woes. Subprime defaults could wallop Wall Street institutions with huge losses, further undermine the already-soft housing market and drag down consumer spending.
In a worst-case scenario, the turmoil could trigger a recession the way the savings-and-loan scandal did nearly two decades ago. The points discussed below can be highlighted as the major impacts of subprime lending crisis on US economy. Subprime Borrower woes- Due to the meltdown in the housing prices the option of refinancing or selling are over. Subprime loans to people with poor credit have ballooned to $1. 3 trillion, accounting for a fifth of all new mortgages last year. For the period July 2006 to July 2007, the paper reported, foreclosure filings increased by 54.
3 percent in the Bronx, 50. 6 percent in Brooklyn and 126. 1 percent in Queens. Subprime lenders- Companies that make subprime loans are already disintegrating because of delinquent and defaulting borrowers. In the past three months, 35 subprime mortgage companies have gone out of business. Of the 25 biggest, about half are out of business or so severely impaired that they are not making any new loans. New Century Financial, the largest US subprime lender has already filed for bankruptcy. Credit Industry- Consumers are not willing to buy homes.
This is because the market for houses is dropping and consumers do not want to loose value on their purchase. Lenders are obligated to improve their due diligence which means that many homebuyers who were previously eligible are not anymore. Furthermore with all the defaults on mortgage backed bonds, investors are not willing to take the risk of purchasing securities which are exposed to mortgages. Stock markets- Dow Jones and S&P 500 were hit very badly. The impact was then followed in other countries like Brazil, Asian countries being hard hit.
But many analysts believe that the impact on the stock market is not very long term as the fundamentals in companies haven’t changed and global growth will translate into higher stock prices in the US. Federal Reserve- The Fed has lowered the interest rates by half a point (0. 5%) in an attempt to lower the impact of the housing and credit crisis. It has also lowered the federal funds rates by 25 points to 4. 5%. It has also injected $41 billion in the money supply so that banks can borrow at a lower rate. Foreign Exchange market- An important effect has been on Yen trade.
The Yen carry trade is a trade where an investor is taking advantage of the very low interest rates in Japan. Here the investor will borrow funds in Yen, pay a very low interest rate and invest it in a higher yielding currency like the US dollar. But the Fed has lowered the interest rates which has resulted in buying back of Yen and selling of Dollar, which in turn has depreciated dollar. Other impacts- A report by the US Labor Department announced that non-farm payrolls fell by 4,000 in August 2007, the first month of negative job growth since August 2003. Thus, these are the major impacts of the subprime lending crisis on the US economy.