Free Example of Causes and Economic Effects Essay

A subprime mortgage can be expressed as a loan that is loaned to customers who have poor credit backgrounds; thus, their qualification to conventional mortgages is limited. Ideally, subprime mortgage charges interest rates, which are escalated, above the normal rates. This is provoked by the increased risk associated with such venturing with such clients. Among the types of subprime mortgages, adjustable rate mortgage is the most common. The start up interest rate is low but later follows  increasing rates. Therefore, unless the client is well explained it can result to misunderstanding. In the United State of America, subprime mortgage crisis is one of the hardest issues that the nation has experience, whose repercussion has resulted into financial crisis. The subprime mortgage crisis was portrayed by an increase in subprime mortgage delinquencies and foreclosures culminating to nosedive in security banked by the respective investors (Demyank & Hemert 2009).

The crisis lead to increase in poor standard subprime mortgage with a percentage of over 18 percent within a period of three years, from 2003 to 2006.  The housing market in America was on the positive increment since access to home loan was non tedious.  The increase in the home price increased, and people secure ample houses in the hope that the prices would continue increasing. However, the house sales prices peaked in the mind 2006 and a steep nosedive followed which made refinancing impossible. The effects that followed increased the negative consequences where by the loss of value of security backed with mortgages and reduction in the purchase of mortgage –backed debt among the international investors. Finally, there was an upsurge in the need to tighten credit worldwide; thus, affecting  the economic growth negatively in the super power countries such as U.S and the European countries (Demyank & Hemert 2009).

Different researches have been conducted evaluate the causes of this crisis that are termed as the second worst crisis in America after the Great Depression period. The causes delineated below were among the input.

a). Drastic increase in number of defaulters

The drastic increase in the number of defaulters and foreclosures that started from the mid 2006 is one of the contributing factors to the subprime mortgage crisis. The effect of defaulting and foreclosure resulted to mammoth losses from the mortgages amounting to roughly over $ 250 billion. The housing industry devised a program to repackage the subprime mortgages into investments; thus extrapolating the extent of the problem. In 2008, the effects were so pronounced that the economy of USA was destabilized. The defaulting was attributed to effect of the loan lenders encouraging clients to secure loans that they could not manage to repay. A crosser look it to the case of foreclosure and defaulting reveals that the number increased due to involvement of loan brokers. These are the people who in one way or another block the bank’s ability to assess for capability of the loaned to pay (Bianco 2008).

b). The Unemployment rate

In most of the areas were the foreclosure was highly evidenced, such as the Midwestern, there are cases of increased unemployment. This was caused mainly by the decision of industries to lay-off employees. The so called the auto industries produced a large number of unemployment people. Most of these people had laid their hope in refinancing for their loans. However, the decline in appreciate rate for the houses brought a significant obstacle in achieving their targets. Many investors were unable to pay their loans; thus opted for foreclosure due to the increasing interest rate in the adjustable rate mortgage.

c). Exploitation of the minorities by lenders

A number of banks encourage the activity of the brokers who managed to convince the clients falsely that prices will continue to appreciate. Therefore, several subprime borrowers acquired adjustable rate mortgages with the hope of prices appreciation. However, several borrowers were unable to meet their expectations of amassing higher payments at the end of the grace year. Refinancing in the subsequent years were difficult; thus, they defaulted. Increase in defaulting and foreclosure contributed enormously to the decline in house prices. The banks suffered mortgage backed securities diluting the net worth and the financial stability of the banks (Demyank & Hemert 2009).

d). Housing Bubble

A house bubble can be described as an economic bubble that takes place in a real estate market, either locally or globally. The period is characterized by increased value of a commodity to unsustainable levels in respect to income generation. The increment in house value was followed by a sudden decline in the home prices and mortgage debt that was higher than the actual value of the belongings.  The subprime mortgage crisis resulted from the busting of the U.S housing bubble starting from the year 2003 to 2005. The condition that favored the flourishing of the growth in the housing market was mainly the low interest rate. This attracted a large number of foreign funds, which in turn, culminated to easy credit circumstances. This led to an increase in house ownership, from 64 percent in 1994 to 69.2 percent in 2004.

The housing bubble led to a few people who had houses refinancing their ventures at a lower rate of even financing it using additional mortgages, which were secured, by the presumed increase in prices. Interestingly, the assumption that the housing pricing would appreciate leaves many people saving minimal, yet they were increasing their mortgage possession. The U.S mortgage debt rose from 46 percent in 1990s to 74 percent in the year 2008, in comparison to GDP. The period evidenced building boom but with minimal selling of the mortgages. Consequently, the mortgage prices begun to decline sharply in 2006, which resulted to subprime mortgage crisis (Bianco 2008).

e). Decline in Risk Premiums

In a report by the Federal Reserve carried out in 2007, the mean differences in the interest rates between subprime and prime mortgages had recorded a decrease from 2.8 percentage points in 2001 to 1.3 percentage points in 2007. Interpretation of these differences indicates that the risk that the lenders needed to offer subprime loans had significantly declined. This decline occurred despite the fact that subprime mortgage borrower and loan particulars dwindled cumulatively during 2001-2006 period. However, this is expected to be the vice versa. The lenders considered the higher risk borrowers for loan irrespective of the fact that chances of defaulting were higher (Bianco 2008).

f). High Risk Mortgage Loans

Before the crisis, most of the lenders were highly interested with making interest, without considering the repercussions of failure to pay. The period recorded an increase in the number of lenders who offered loan to high risk borrowers. The regulations that governed lending were highly overlooked in the period of 2004 to 2007 (Bryant & McGrath 2011). There are reported cases of lending to undocumented immigrants who benefited from the housing, but did not consider repaying the loan. Moreover, lending was characterized by increasing risky loans and unnecessary incentives aimed at attracting more borrowers. For instance, the deposit require before acquisition of a loan was no longer a must. In 2005, at approximately two fifth of the borrowers had not made any down payment.

The qualifications for securing loan were redefined, and most of measures aimed at minimizing risk of untoward debt were often overlooked. The banks no longer asked for proof that the borrower had income. This resulted to a  loan that was referred to as stated income verified asset loan. This was later followed by no income, verified asset loan. In this form of  a loan then, the borrower was only required to show proof of having money in the account but the source was not an issue. This posed a considerable risk since the consistence of the fund was not guaranteed (Bryant & McGrath 2011).

As the competition to offer loans increased, the urge to attract borrowers resulted to the emergence of no income no asset loans. Borrowers needed not to have any income or asset as a security for the loan. All that was required was a credit score. It was believed that lenders took their client by faith on issues to pay the loan, instead of the evaluating the ability of the borrower to pay the loan. This resulted to an increase in mortgage fraud. The emergence of these high risk mortgage loans was indeed a pivotal cause of the subprime mortgage crisis (Tong & Wei 2008).

g). Securitization Practices

Securitization is described as practice where by income generating assets, receivable are bundled to create profit making pools that are sold as collateral to third party investors. This is a practice that started in the 1980, in the American housing industry. The causes of this practice that contributes to the crisis were that the risks of defaulting were not transferred to the securitization body. The bank had to suffer both the interest rate risk and the defaulters risk while the Government Sponsored Enterprises transferred only interest rate risk (Tong & Wei 2008).

A vivid association between the securitization and crisis is seen in the mistakes that resulted from way the underwriters, rating agencies and businessmen defined the correlation of risk among the securitization pools. The model used was based on a Gaussian copula technique that was proposed by David Li. The technique was later identified as having ample flaws, which were evidenced after the crisis had occurred.

h). Policies

The failure of the government to formulate policies that should have prevented the emergency, exploitation or regulation of the emergency loan types, is a core cause of the crisis.  For instance, there was uncontrolled lending of the adjustable-rate mortgages. During the leadership George Bush, the state interfered with an investigation that was aimed at identifying repercussions of the housing bubble. Community Reinvestment Act is one of the policies that many economists hold to be a contributing cause of subprime mortgage crisis. Economist believed that this policy led to lending under worthy consumers (Pritchard 2012).

Economic effects

The crisis lead to financial crisis in America, which latter transcended to other parts of the world. Noting that Ameriac is a super power, the world’s economy is largely influence by the fluctuations of the dollar. Therefore, economic crisis in America is usually felt in most part of the world, thought at different magnitude. Among the effects of subprime mortgage crisis on economy include the following;

a). Impact on the Stock Market

There was a mammoth drop in the stock market all over the world. Most the giant companies were affected drastically, and daily decline in the stock holdings became a common phenomena. For example, Korea Composite Stoke Price Index recorded a drop of 7 percent in a day. The drops in the stock market were directly linked to the crisis due to the increased number of defaulters.

b). Effects to Banks Operations

Following the financial effects caused by the subprime mortgage crisis, several banks have recorded massive losses in the past few years. A number of the banks such as the Barclays, Citigroup and UBS among others have posted significant write-down.  The banks raised concern of increase in the scale of losses that they were extrapolating to record in the year 2008. This was expected to have a propagated long term effects in the bank’s operations. Some of the consequences that can arise from leading banks write downs include negative effect on the cash supply; exchange rate  of the dollar would be expected to go down, a decline in the interest rates among the banks and finally worldwide inflation. Inflation will consequently lead to increases in cost of living (Bianco 2008).

Lowering the bank interest will automatically culminate to decline in the profits gained among the banks. With reduced interest being earned, the banks will reduce the ability to offer loans to the individuals, companies and even the government. This means that the rate of development will be struggled still affecting the economy (Tong & Wei 2008).

c). Unemployment

The financial sectors in the world faced financial challenges in their operations. To ensure that the banks do not close down due to bankruptcy, they opted to reduce the number of employees.  Major financial institution engaged in lying off employees in the year 2008. Examples of such institution include Citigroup that lay off a total of over 9000 employees; Merrill Lynch had plans to lay-off 2,900 employees. In a research conducted by Department of Labor in America, indicated that the financial institutions had set away 65,400 employees.

d). Housing Industry Stagnation

Many businessmen, who were interested in venturing in the field of housing, will be shut down by the crisis effect.  It will take time before investors comes in-terms with the reality that such a period can be overcome. Those willing to construct mortgages will need more time to have the crisis settled and new hope reinstalled that such a situation will be prevented from happening again (Bryant & McGrath 2011).

Following the increased rate in the number of the cases of defaulters and foreclosure, people have been frustrated by the crisis to a point of turning into arsonist. They in America, the FBI unit have raised a concern of increased cases of house destruction. This is a method that they are using to prevent themselves from paying for these mortgages. The economic implication is that many investors will count massive losses. This will culminate to developmental stagnation of the housing industry; thus hindering the attainment of one of the basic human need.

e). Decline in mortgage owner net worth

There were speculations of increase in foreclosure and defaulting. As a result, the country was characterized by surplus unoccupied houses which have reduced the drastically the prices for a mortgage. In 2006, the house price index in U.S was valued at 8 percent and 20 percent during the year 2008 (Bryant & McGrath 2011). Mortgages that were not paid fully  were foreclosed forms perfect places for thugs to hide themselves at night. Consequently, there is increased crime in the villages that cause reduction in development. The falling net worth of the houses affects directly the economy due to the hindered developmental growth in the country.

Conclusion

The mortgage crisis should be taken as a challenge so that the state will be a bit more careful with legislation to prevent avoidable errors. The common causes of the crisis as discussed earlier include cases that could have been corrected for worthwhile results.  The government should have intervened for failure and lay down policies that shields it citizens. The housing bubble, Drastic increase in number of defaulters, the unemployment rate, exploitation of the minorities by lenders, housing bubble, decline in risk premiums, high risk mortgage loans, securitization practices and policies is some of the major causes of  subprime mortgage crisis. The crisis was identified as leading to a number of economic effects as described in this paper.