The paper is a critical examination of what led to the 2007 subprime mortgage crisis in the United States of America. It is worth noting that the subprime mortgage crisis is a financial as well as real estate crisis that occurred between 2007 and 2010. Subprime refers to the credit characteristics of individuals who borrow money from financial institutions. These individuals do exhibit weak histories regarding credit repayment.
It is worth noting that the subprime crisis is attributed to a number of causes which include the following; refining of the mortgage loan and adjustable-rate mortgages, it is important to remember that borrowers were encouraged to borrow more money due to increasing loan incentives, for instance, low-interest rates (DiMartino & Duca 45). Additionally, the rising demand for houses coupled with an increase in houses prices pushed borrowers to take more loans to invest in real estate. At the time banks started feeling the pinch of providing individuals with huge loans, they started raising the interest rates. The increase in interest rates meant that it was difficult to refinance loans taken and for that reason, individuals opted to foreclosure as default on loans taken increased. Additionally, although borrowers expected the prices of houses to go up as demand for the same was being anticipated to rise, there came a time when the prices of houses (housing bubble) declined so drastically that made those who had invested in real estate default their loan. Some opted for foreclosure and applied for bankruptcy.
High-risk mortgage lending is another reason that led to the subprime crisis. It is worth noting that financial institutions offered loans to higher-risk borrowers; an example of such includes immigrants who are not documented. In total, the mortgages for subprime borrowers totaled $35 billion representing 5% back in 1994, and rose drastically standing at 20% in 2006 (DiMartino & Duca 90).
As suggested by Reinhart & Kenneth 52, the mortgage originators and securitization is another cause of the crisis. Traditionally, mortgage models entail banks originating loans to individuals who wanted to invest in real estate and the bank would retain credit risk. The issue of securitization has seen to it that a new model ‘originates to distribute’ model where banks sell the mortgages and distribute credit risks to investors via mortgage-back securities, as well as collateralized debt obligations, came to play. This concept made it possible for banks to bundle loans into a package and resell them making it possible for financial institutions (banks) to have more money to lend which meant that borrowers had a risk of defaulting repaying their loans since there was more emphasis to incentivize the processing mortgages while no efforts were being made to ensure the quality of credit for the borrowers.
Mortgage fraud is also thought to be another cause of the problem. It was established that mortgage fraud was ubiquitous when the condition was heavily characterized by collapsing lending standards as well as lax regulations. Between 1996 and 2005, a suspicious criminal activity linked to mortgages fraud grew 20 fold then doubled between 2005 and 2009. It was estimated that losses resulting from such fraud amounted to about $112 billion between 2005 and 2007 (Muolo &Padilla 104). I believe investors invested in the securities that are backed by subprime mortgage loans despite the fact that such loans were risky because they were speculative and hopeful that the prices and demand for houses will keep on rising. Additionally, they were not required to hold them to maturity meaning that they could still sell the same to other potential investors (Clark 18).
Clark, Kenneth. Legacy of Greed: The Story behind the Mortgage and Housing Meltdown. New York: Author Solutions, 2007. Print.
DiMartino, Davis. & Duca, Victor. “The Rise and Fall of Subprime Mortgages,” Federal Reserve Bank of Dallas Economic Letter, 2.11. (2007): 2-17.
Muolo, Paul &Padilla, Matthew. Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis. Hoboken, NJ: John Wiley and Sons, 2008. Print.
Reinhart, Carmen & Kenneth Rogoff. Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison. Harvard University working paper, 2008. Print.