The History of subprime mortgages in the U.S
Subprime mortgages are mortgage loans awarded to poorly qualified homebuyers. This practice dates back to the 90’s when lending institutions due to competition turned focus to serve low-income earners. This category of homebuyers was less attractive to many lenders and those who ventured into it usually charged higher interest rates.
Due to high profits, lenders shifted focus to offering subprime mortgage loans consequently leading to a steady rise in demand. The increased demand for subprime mortgage products shot steadily through the 90’s and early 2000’s. The desirable side of this practice was that it enabled many Americans to own homes, which otherwise they would not have owned under the conventional house ownership protocols.
On the other hand, it became the greatest contributing factor to home foreclosures in the United States. Between 2000 through 2006, the rate of home foreclosures became increasingly high that it triggered a number of studies, which strongly indicated subprime mortgages as the prime root cause. The studies further revealed that subprime mortgage loans were typically Adjustable Rate Mortgages (ARM), which charge attractively low interests, but in subsequent periods, the rates are reset upwards.
The high rates made it very difficult for borrowers to service their loans. The increased mortgage servicing failures and collateral take-ups by lenders led the United States’ federal government to step up the scrutiny on the practices of subprime mortgages.
Causes of subprime Mortgage crisis
The prime contributing factor to the United States mortgage crisis was that the lenders had set high expectations without proper appreciation of the risks involved. At the core of the rampant loan defaults, lay the moral hazard coupled with weak underwriting standards, poor risk management practices and excessive vantages. Following are the probable causes of the Subprime mortgage crisis.
The boom in the housing market that led to housing bubble attracted many investors and other players and suddenly hit the peak after which the mortgage crisis set in. On the onset of 90’s, the US market was characterized by low interest rates and huge inflow of foreign funds. This situation made it easy for access of credit facilities thus the Americans were encouraged to fund projects with credit. The anticipated result of such environment is reckless spending without putting into consideration repayment modalities in the future.
As a result, savings became less, borrowing shoot up and spending was always high. The introduction of subprime mortgage in the prevailing economic conditions became attractive to home buyers and therefore investment in real estate became very attractive to investors (Krugman 114). This trend continued hitting the peak at around the year 2006 when the built homes became so many and the number homebuyers had come down.
Easy credit access and continued house value appreciation encouraged borrowers to take adjustable rate mortgages (ARM) which charged lower interests at the start of loan repayment but later adjusted up. The borrowers then could easily service the loan during the early stages after which they would start having trouble in servicing the loan and eventually default. The number of borrowers defaulting on mortgage loan repayment steadily rose followed by foreclosures resulting to more houses for sale.
The increase in houses for sale pushed house prices downwards thus reducing the homeowner’s equity, which also led to reduction in value of mortgage-backed securities. Crisis is the only best word to describe this situation; people borrowed to build house, defaulted loan repayment and prices of the houses built by borrowed money dipped in a very short time.
The other cause of the crisis was speculative borrowing which had set in due to the booming housing business. When the housing market hit its peak in 2006, speculation went down and the speculators left the market, a factor that accelerated the crisis. Again, without speculation, market players are bound to engage in poor practices that would obviously overlook any dangers that might arise in the future. Also seen has the root of moral hazard was the leniency to borrowers by lenders, a highly risk practice.
The lenders awarded mortgages without getting proper documentation of the borrower’s information. The lenders did not appropriately asses their clients to ascertain whether they had stable sources of income; all they did was to see the bank statement. In addition, the repayment terms were convenient to the borrowers especially with the adjustable rate mortgage arrangements. Consequently, when reality checked in default was the only option and in face of defaulting loan repayment, foreclosures were inevitable and hence a crisis.
Another factor that fuelled the housing crisis was the inaccurate credit ratings. The rating agencies gave in to unrelenting demands from the investment banks and other firms that sold securities to investors. The conflict of interest was due to the payments the agencies received coupled with faulty computer models led to major inaccuracies in the credit ratings. Equally, the government had its lion’s share in fuelling the housing crisis (Dwight 28).
In their top agenda, most of the US presidents including Roosevelt, Reagan, Clinton and Bush, was to increase home ownership among the United States citizens. This policy led to high deregulation of the banking industry. According to Dwight, the congress passed “the Alternative Mortgage Transactions Parity Act (AMTPA), which permitted non-federally chattered housing creditors to offer mortgage loans” (30). In addition to the government’s actions, the central bank to some degree contributed to the crisis.
The central bank in the early twenty first century lowered the interest rates citing low inflation rates. The low interests aided in fuelling the housing bubble. The lowering of interest rates based on low inflation was not justifiable as other important factors were overlooked.
As early stated, during this period of housing boom foreign funds were finding their way into the US economy. Since the investments exceeded their saving this justified the outsourcing of funds. The heavy inflow of foreign funds led to a deficit in the US balance of payments. Kolb observes that, “between 1996 and 2004 the balance of payment rose to a deficit of $650 billions…because the Americans borrowed these funds to finance consumption or to bid up the housing prices and other financial assets” (16).
On the other hand, the foreign lenders supplied money to the US through the purchase of US treasury bonds that are very secure. The aforementioned factors are just but a few causes of the subprime mortgage crisis that hit the US from the 2007 and its effects are felt to date. Ensuing are the solutions for the subprime mortgage crisis.
There are a number of interventions available to try reversing the effects of the subprime mortgage crisis. The first agency for intervention would be the US federal and the central banks, which would unleash a series of monetary policy actions to increase liquidity in the US economy. Such actions would include open market operations and direct lending to commercial banks and no-banking institutions. Secondly, the US government would also step in to rescue the economy through appropriate legislations.
So far the US has passed two legislations inform of the economic stimulus bills. The first, was the 2008-$168 billion economic stimulus package which was mainly to be used to refund taxes directly to the taxpayers. The second bill, American Recovery and Reinvestment Act 2009 aimed at giving tax cuts and increasing spending.
In addition, the troubled banks should act appropriately to replenish the lost capital. The mortgage crisis led to losses of value of mortgage-backed securities thereby, rendering the banks insolvent. In order to access additional capital from private investors, the government can accept to be guarantor to the mortgages to increase security and in turn encourage private investors to buy the securities. Other steps would include bailing out the troubled banks by the federal reserves to save them from going insolvent.
Also to the homeowners, instead of the lengthy foreclosure proceedings, the banks can negotiate and arrange alternative loan servicing options. As elucidate din ten causes of this crisis, the central bank and the federal government were involved in creating the problem and they should play the central role to avert the crisis for they have the moral authority and resources to facilitate the recovery process.
Policy changes to curb future reoccurrences of the same
A number of actions and changes that would possibly reduce future reoccurrence of the subprime mortgage crisis would include the following; first, it is important that proper procedures be instituted to guide the closure of troubled financial banks. Secondly, ceilings should be set for the maximum amount of vantages financial institutions can assume. The non-banking institutions that act like banks should also be regulated to provide a level playing ground.
Further, the mortgage qualification requirements should be revised and that the down payment should never be set below 10% of the total value. In addition, the system must be structured such that it can detect early risks and issue warning thereof.
Risk management and contingency planning are becoming vital elements in any institutions whereby, management is using the two as indicators of the future. It is true that the future might be unpredictable; nevertheless, preparing for the worst and planning for the best might cushion institutions from avoidable crises like the US subprime mortgage crisis. These are but a few changes to curb future reoccurrence of the subprime mortgage crisis.
Subprime mortgage crisis ranks the worst financial crisis to hit the United States since the great depression in the 1930s. The study has systematically analyzed the subprime mortgage facts and highlighted the factors that contributed to the full-blown crisis. Further, there are some possible solutions and policy changes to prevent a repeat of the subprime mortgage crisis highlighted in this paper.
Subprime mortgages were however effective, for in stance they financed close to 5 million home purchases where a majority were the low-income earners who otherwise would have not done so. This was fully in line with the US government policy to increase home ownership. The subprime mortgage crisis case provides numerous lessons the developing economies with high-risk securities can draw lesson from and formulate appropriate policies to curb a similar crisis.
Dwight, Jaffee. The U.S. Subprime Mortgage Crisis: Issues Raised and Lessons Learned. DFID, The World Bank, Working Paper no.28, 2008. Print.
Kolb, Robert. Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future. New York: Wiley, 2010. Print.
Krugman, Paul. The Return of Depression: Economics and the Crisis of 2008. New York: W.W. Norton & Company Limited, 2009. Print.