Financial institutions have crumbled down as hundreds of billions in mortgage related investments went stale. Some of the world’s largest financial institutions were seized by the government. This even led to a bail out initiative by the government in order to save the worsening condition of the housing industry. This study will focus on subprime mortgages and how these had caused a housing crisis. Much worse, how this crisis in the housing industry has affected the national economy as a whole.
This paper will present an analysis of subprime mortgages and its relation to housing crises. This paper will examine the nature of subprime mortgages. A definition of subprime mortgage and a distinction between prime and subprime mortgages will be provided in order to provide a launch pad for this study. Having established these definitions, this paper will then identify the process in which subprime mortgages are awarded and to whom these are awarded.
Next, this paper will determine the extent in which subprime mortgages has affected the housing economy and in turn, the national economy. Lastly, a brief description of the recent crisis brought about by the credit crunch instigated by subprime mortgages in the U. S. housing industry. Secondary sources will be sought through library and archival research. These will be utilized to expose the nature of subprime mortgages and its relationship to housing crises. Internet sources from credible institutions will also be used because of their timeliness with the subject.
A content-analysis of various secondary sources will be employed in order to achieve the objectives of this research. Body of the Paper “Subprime” is a term used in the financial industry to describe borrowers, who are not qualified for a “prime” loan. A prime loan, on the other hand, is a loan that charges an interest rate equivalent to the prime rate, which is published in the business pages of the newspaper (Brownell, 2008). A subprime borrower is someone, who has undergone a poor payment management in the past and has a low credit score (Johnson, 2008).
The credit score represents ones capability to make payments for his financial obligations and is usually issued by the Fair Isaac Corporation or FICO (Brownell, 2008). Subprime borrowers pay a relatively higher interest rate to compensate for the additional risk lenders may incur with their loans (Johnson, 2008). About 80 per cent of subprime borrowers were given adjustable rate mortgages, otherwise known as ARMs (Waldron, 2008). ARMs begin with a low interest rate. Sometimes, these are lower than those of a fixed-rate mortgage.
However, the interest rates increase in about two or three years, increasing the monthly payments by hundreds or even thousands of dollars. This in turn brings difficulty for borrowers to comply with. Those people who cannot afford the rapid monthly increase might eventually go into foreclosure thus, losing their homes (Waldron, 2008). After the World War II, the real estate market in the United States has benefited from the high levels of demand and increases in the price value of both new and existing residential and commercial properties (Ventolo, Ventolo & Williams, 2008).
Home ownership was once considered to be a key for a middle class American to secure his future. After the World War II, the government has encouraged massive home ownership, as well as low cost housing. However, home ownership nowadays might lead to a lifelong debt (Johnston, 2007). According to data from the Federal Reserve, Americans owned around two-thirds of the value of their houses back in the sixties and the seventies; the rest were owed in mortgage debt. In 1981 and 1982, 70 per cent of the value of American homes is in equity.
However, in 2006, equity shares in homes have decreased tremendously while mortgage debt increased to almost 50 per cent of the total value of American houses (Johnston, 2007). Today, debt account for more than 50 per cent of the price value of American homes. Home values are falling in most American communities due to high debt burdens. These amounts can no longer be covered by the owners and there are no buyers who would like to take over for the owners at current prices (Johnston, 2007).
This historic turning point in American economy and culture was known to be the subprime crisis. This crisis was triggered by very aggressive mortgage lenders and unworried borrowers who did not worry about not paying their mortgage (Shiller, 2007). Mortgage lenders become complacent about the risks that they might encounter with subprime borrowers due to the fact that they can easily sell off these subprime loans to investors, who in turn, will take care of the risks for them (Shiller, 2007).
In this process, the original lender will sell the subprime mortgages to investment bankers, who will subsequently use them to avail bonds known to be mortgage-backed securities (Johnson, 2008). Due to the boom in the housing industry, mortgage lenders has failed to exert due diligence in scrutinizing the financial abilities of the borrowers (Johnson, 2008). To some extent, some people, in spite of their poor credit histories, are enticed by mortgage lenders to take loans (Shiller, 2007).
As many borrowers defaulted in the payment of their mortgage, the bonds, which were backed by these loans, have lost significant value, creating financial instability in economic markets (Johnson, 2008). The financial market is now being fully flooded by the subprime crisis. The banking sector had been the center of the current economy turmoil, reflecting the malfunctions in the money market (Felsenheimer & Gisdakis, 2008). The meltdown in the US mortgage industry started the series of unfortunate events that led to the massive economic crisis.