The Ultimate Fall-Out of the Subprime Crisis - Essay Example

THE ULTIMATE FALL OUT OF THE SUBPRIME CRISIS Introduction Subprime as used in the US is a term which refers to the loans which specifically don't meet the Fannie Mae or Freddie Mc lending guidelines. In general use Subprime lending is a term which is used to refer to the lending which is made at a higher rate than the conventional prime rate. Therefore Subprime lending may not reflect the credit status of the one who is borrowing the loan since it may not reflect the rate of interest that is being charged on the loan. However Subprime leading is also used to refer to the bank loans which are taken on property which cannot be sold in the primary market. This may include the loans that are advanced on some types of investment properties and to some self employee individuals. (Karen, 2007, p. 6) As such Subprime lending can be taken as one of risky activities not only for the borrowers but also for the lenders. This is due to high interest rates, frequent poor credit histories of the borrowers, potential adverse financial situation which may be encountered by the borrowers and others. This study will look at the Subprime problem that has rocked the US market and other markets in the world as well. There has been increased rate of home foreclosure and millions of the US homeowners have lost their homes. There is a general panic that has rocked the industry with so much uncertainty about its future. The paper looked at the Subprime crisis but leaned on the potential fall out of the crisis. This study is important since other studies which have been carried out on the subject have concentrated on the overall cause and trend of the crisis but few have looked at the potential fall out of the crisis and its consequences. The objective of the study was to understand the trend in the crisis and therefore predict the potential fall out. The study was carried out by collective, reviewing and analyzing secondary data in order to put facts together to understand the potential fall out of the mortgage. There were few problems that were encountered in the study but the problem of access to the relevant material that could give an insight into the study was encountered. It also become difficult to carry out a primary data collection since most of those who were selected for interview declined. From the study the authors has understood the trend in the current mortgage crisis, its causes and the potential interacting factor that have made it difficult to resolve it. The author has also understood the potential fall out of the crisis and from this it has been easily to come up with the possible strategies that could be used in the future in order to avoid the repeat of such a crisis. Therefore the study has helped the author to understand the effects that Subprime crisis is likely to have on the lenders and borrowers as well. Aims and objectives of the study The main aim of the study was to look into the Subprime crisis that has currently rocked the US home industry which has also been felt in other countries as well. In order to understand the topic well, the research was also aimed at looking into the developments in the Subprime crisis so as to come up with an understanding of the crisis and potential fall out and its effects on the homeowners. Therefore the main aim of the study was to study the ultimate fall out of the Subprime crisis. To achieve the aim of the study, there were specific objectives which had to be fulfilled first. This was important in order to understand the trend in the crisis and the potential consequences. The following were the objectives of the study; To assess the main factors which have contributed to the Subprime crisis To asses the trend in the Subprime crisis To evaluate the extent of damage that has been caused by the crisis To evaluate the potential effects of the crisis Through the achievement of the objectives the study was able to understand the subject of study well and to draw upon conclusion on the potential effects of the crisis. Therefore they were important in helping the study to achieve the overall aim of the study. Literature review According to Morgension (2008m, p. 8) Subprime lending has developed over the years with a realization that there is a high demand for relaxed lending laws in the market. In the conventional lending, lenders had been very cautious when giving out their loans and they had in many times turned away potential borrowers when they found that they could not meet the credit worth criteria set out in the lending institution. It has been shown that it is more than 25 percent of the US population which falls under this category. This means that most of the US citizens could not have had opportunities to purchase homes were it not Subprime lending. Subprime lending has become useful in the US market over the time especially with the increasing housing boom. By 2007, Subprime ARMs reopened about 6.8 percent of the all the mortgages outstanding but at the same time as the crisis rocked, they rose to 43% of the crises and foreclosures. On the other hand Subprime fixed mortgages represented a standing 6.3% of the all the outstanding loans in the US and as the crisis started they represented 12.0% of all the foreclosures. This clearly indicates that the Subprime business has growth very fast in the country and has been playing an important role in assisting the US citizens and others in the world to acquirer homes which would otherwise prove difficult for them. According to Austan (2007, p. 5) the Subprime sector is one of the most important sectors in the US home industry. It has been estimated that there are more than $265 billion of the Subprime loans which have been given out in the three years. The outstanding mortgage is valued for more than $1.3 trillion which has been compared to the size of the California economy. It was estimated at the US property markets which experienced a weakness in 2006 would have made a major recovery but Subprime loans still accounted for about 20% of the overall growth in the home ownership industry in 2007. As had been illustrated by the housing bubble which rocked the US economy in the previous years, it is very clear that any change in the housing sector is likely to percolate to the whole economy and if not well managed its effect may affect the operation of the whole economy as well. Berlau (2007, p. 32) shows that since the 1990s, there are a number of factor that may have contributed to increasing Subprime lending in the housing business. Some of these factors included; There was an increased income which was also marked by lower tax rates which made it possible for a number of people who had modest means to purchase their homes for the first time. There were innovative financial products which included some adjustable mortgages, interest only mortgages and low documenting which encourage more people to purchase their own homes and provide more opportunities for others. There were various new investment strategies which were pioneer by the private hedge funds including Freddie Mc and Fannie Mae which were actively backed by the government. The mortgage lenders themselves made active appeal to the public to get additional loans in order to own their own home. There was entry of many other firms in the mortgage industry many of which were mortgage only lenders. These first were willing to accept lower profits and they wrote loans which could not have been awarded to their customers before. As has been evidence the increase number of the lender firms which have been affected by the crises and which have been declared bankruptcy, there is a clear reflection that most of these firms were poorly managed. These are some of the factors which could have contributed to the increased rate of home ownership in the US. The industry soon looked very lucrative and there was massive exodus of investors into this industry which saw an increased rate of growth of the industry. There were many new housing units that were coming up with time and as the industry grew there were more investors and lenders who were coming to the industry. This led to a housing boom in which many new housings units were constructed ready for sale. Like in any other market an expansion is followed by a decline when the industry cannot absorb anymore. Therefore this increased explain of the industry could have been one of the factor that led to the eventual fall of the Subprime industry. By the start of the 2006, the US Subprime mortgage comes to another phase after a constant growth for a number of years. (Tempus 2007, p. 8) The industry entered into a historical crisis which was first referred to as economic meltdown in the industry. This was a phase which was marked by a high rate of Subprime mortgage defaulters and an increased foreclosure which saw more that 100 Subprime lenders declared bankruptcy. The nation's second Subprime lender institution New Century Financial Corporation was also declared bankrupt. The effect of the crisis ahs been far reaching and has seen the collapse of $6.5 trillion industry which has been previously backed by securities. This has been feared to have broad effects on the US housing market which is large economic sector in the country. However the effect of the crisis was not only felt in the US but they were also felt in other countries as well. It has risen to global concern as other markets in the world came to be affected by the crisis as well. This crisis affected the European and the Asian market as well which has stronger ties with the US supreme market industry. It is asserted that toward the end of 2007 there were more that 160 American mortgage lenders who had been declared bankrupt. As the rate of home forecloses continued, there are more and more Americans who are going to be left homeless. It is showed this as a naked truth that there are more Americas who will be left homeless if there is nothing that is done to save the situation. He shows that one of the factors that have contributed to the increased rate of foreclosure had been the enticement of the lending agencies which encouraged more and more Americans to take loans which they could not afford to pay. As the home crisis bite, many of the homeowner found their home valueless and therefore they could not afford to repay the loans that they had taken earlier. As more companies face the risk of being foreclosed, there will be more Americans who will continue to lose there home. But even as the crisis bits deep, there has been little changes that have been observed in the US consumption pattern. The US saving ratio has constant remained on the negative side which means that the consumers are spending more than their real income. It has been noted that the rise of the consumption culture has forced some to borrow in order to spend. This has been risk strategy that could have been one of the factors contributing to the problem. There are other consumers who have been engaging in mortgage equity withdrawal. The negative saving ratio is practically insatiable over a long period of time but can be seen as attractive in the short period. (Blundell 2008, p. 89) A recent study has revealed that about a third of all the US homeownership can be considered as a Subprime mortgages. This means that more than a third of all the homeowners do not actually qualify for a mortgage of they are not worth owning those homes. They cannot pay for the homes that they are living in. This may have been traced as the main roots for the crisis since there is a general lack of confidence in the industry. The lending institution therefore considers a third of those who had been granted loans to own homes as incapable of owning their own home. In several ways the Subprime crisis in the country has created a very unstable market in the completed and the pre constructed houses. Many have consequently questioned when the crisis is likely to end in the court. There is already a global credit crutch that has affected several markets and many already fear the effect of the crisis especially on homeownership. Homeownership value has also been plummeting to record low and currently it has been shown that the homeownership is 25% less that it was in the least one year. The most disheartening thing is that there seems to be no end of the crisis in sight. Although many have struggled to look at the real cause of the crisis and understand whose fault it is, there is no answer for this question. There are many parties which can be attributed to the current crisis rocking the industry and no one party can be faulted. Every one can be taken to question on the problem of the crisis and at the same time every one in the country is a victim of the crisis Banks have been held responsible for the crises based on the fact that the concluded with the lenders to finance 100% purchase or construction of new home to some people who could not afford to pay these loans. Lending institution had various incentives which were meant to raise the need to the mortgages among the population and they did not give any advice on what were likely precautions for the loans. They were led by their need to make more profits. Those who could not afford to be given loans should not have been allowed to access these mortgages since they would at the end default in their payment. The lending institution did not make any such kind of comparison. The government has also been held responsible because once it understood the increasing demand for the Subprime mortgages it would have stepped in and put some regulation in order to safeguard the integrity on the industry. The government however did not take any action in order to regulate the operation of the industry. It left the industry to regulate itself but the lending institution could not come up with important regulation that could have ensured the smooth running of the industry. The homebuyers have also been faulted on the rising crisis because they had a lot of greed to amass wealth. The capitalism culture had crept on them and they just wanted to accumulate more and more. They did not care about the effects of the crises but they continued to built and buy more houses. Therefore we can see that every one can be held responsible for the spilling crisis. All the parties who were involved in the home buying transactions can all be held responsible for the increasing crisis in the industry. There are several unfinished housing units that are lying idle which have been abandoned and the crisis is still continuing. There is no solution in sight for the crises as long as the government will not come up with plan to rescue the failing lenders and at the same time put in place strict regulations which will government the operation of the industry. (Rick and Ruth, S 2007, p. 9) Methodology In any study, the methodology used is important as it determines the overall success of the study. The methodology outline the data collection method that was used in the study and it also give important understanding of the various components of the study subject. The methodology is also important in determining the overall success of the study based on the validity and the reliability of the data collected. This study was a qualitative research design. Therefore it employed a survey research design. A survey research design was the most appropriate for the study since it provided an opportunity to look into different data that have been presented on the subject from various source. A survey research design also gives the study the freedom of choosing the source of the information since it had few restrictions. In order to have an effective study of the subject, the research looked into various data that have been contributed but difference people on the subject. The study decided to use secondary data sources since they allowed a wide range of coverage of the topic and to understand this topic well, one need to have a lot of information about the whole subject. Prima research had been considered for the study but it had to limitations: First those who had been selected to be interviewed declined to schedule and interview with the research. It was only 20% of those who had been selected accepted to be interview. This interfered with the validity of the data collected and therefore secondary source were preferred Second the use of primary research would have narrowed the data collection span since it the time frame would have allowed for an interview with very few individuals. This meant that the study would have concentrated on input from a few individuals which could have not validated the data collected. Therefore secondary source of data was considered since it allowed the research to carry out data collection from unlimited number of sources. Data was collected from a number of reliable sources including the government printouts, home industry journals, past researches on the subject, and many others. In order to collected a wide varied data and compare individual input on the subject, the study also considered individual input in the study. This was important since the subject of study had elicited different views from home specialists. Consideration of individual input was therefore important in ensuring that there was enough data for comparison. Data analysis and presentation The collected data was analyzed using simple data analysis process. This was a qualitative study and therefore simple data analysis procedures were more suited for the study. The main data analysis procedure involved review of the information that has been collected on the subject and validating it with other information. The government sources were particularly taken as the primary source for the data and the other data was just for comparison purposes. The following were the main results of the data collection process; As far as most of the American as concerned, a Subprime mortgage is understood here as a method in which the buyer uses the property as a security for an obligation. In other words, this means that the proper is used as a guarantee for the loan an in case the borrower fails to repay the loan, and then it means that the lending institution will carry out a foreclosure of the property in order to recover the mortgage debt. (White and Hirschhorn, S. 2008, p. 8) Any of the amounts that will then be received from the property will then is used recover the loan for the property. According to this understanding, it means that the lending institution will sell the property at a less amount than what was originally borrowed. Therefore the customers will not go at a loss. It is such an understanding that motivated several customers to take mortgage loans since they did not consider it as a loss. Many lending institutions required the buyer to offer a down payment of the about 20% and then borrow the remaining amount. This means that the buyer is likely to have a 205 input in the loan equity. The institutions provide two types of loan mortgages. The interest only mortgages offer loans which require the borrower to pay only the interest portion of the loan for the first few years and therefore keeping the payment low for the first years before the interest the interests can experience. However the borrower must pay the principle and interest components for the mortgage payment. Adjustable rate mortgages unlike the traditional fixed mortgages so that the payment is the same every month. There is adjustable rate mortgage in case the interest rises and the mortgage payment is likely to go up as well. On the other hand low initial fixed rate mortgages offer mortgage that initially have some very low fixed rates and then they quickly covert to the adjustable rate mortgages. The Subprime mortgage crisis was found to have started in 2006 immediately after the housing boom which has made several people to take loan in order to by houses. As a result there were more houses in the market and most of those who had taken loans could not repay them. This led to a general panic in the industry and many of those who had taken loans started to default. The following were the main cause of the crisis according to the data reviewed. From the 1990s, there was increased availability of loans which were lent to those who wanted to buy homes. There revolution of the Subprime mortgage meant that even those who could not afford to pay for the conventional loans were this time likely to be given loans by the lending institution. Increased mortgage lending enticed many people to enter into the home buying industry and therefore there was increased lending. The lending institutions found this as an important opportunity and they further eased the condition for advancing Subprime credits. This attracted many people to get repeated loans as the industry expanded. As the housing price increased in 200 to 2005, borrowers found it easy to repay their mortgages and therefore they were encouraged to borrow more in order to build more houses. However when the prices started to plummet in 2006, they found it difficult to repay their loans and many started to default. The government failed to take appropriate measures in order to regulate the industry that had started to grow very fast. When the government realized the potentiality of the growing sector, it would have moved in immediately in order to provide guidance on how the industry was to be run. The government failed to act to put in regulations to govern the industry and therefore the integrity of the industry was highly risked. For example the recent arrest of form Bear Stearns hedge fund manager Mathew Tannins is a clear indication that failure by the government to put regulations in the industry could have compromised the integrity of the industry. Mathew is said to have lied to the investors about the collapse of the Subprime mortgage market. The government has been widely accused of failing to make effective oversight into the operation of the government. Mortgage brokers have also been criticized for steering the unaffordable loans which led to the inflation of the loans. This also led to increased inflation of the housing values. The mortgage brokers did not assess the credibility of the borrowers to ensure that they were able to meet the needed criteria for the mortgage. Since most of the brokers were paid based on the number of the customers they could bring, most of them enticed borrowers to take loans in large numbers. The brokers were in many cases backing Subprime mortgage security in without an effective verification of the strength of the underlying mortgage loans. Mortgage borrower also contributed to the crisis in the sense that most of them did not consider their ability to repay the amount they had borrowed. Borrowers entered into agreement to take loans which most of them were not able to repay. This had an adverse effect in that most of them could not repay their loans and the rate of defaulting increased. As the crisis bit most of the borrowers found it difficult to deal with the amount of loans that they had borrowed and therefore they started to default. This means that most of the lending institutions could not recover their loans. (Jenny 2007, p. 3) These are the prime factors which led to the near collapse of the mortgage industry. These were found by study to be the main players in the industry. All of them have been responsible for the near collapse of the industry. Therefore it is these conspiring factors that have made it worse for the collapse of the mortgage sector. There are several effects that are likely to be felt from the crisis. Currently there are about $1.3 trillion of mortgage that has not been paid. There are also approximately 20% of the outstanding home mortgages that are Subprime. The study also found out that the great bulk of the loans were borrowed out in 2005 and at the beginning of 2006. This was the period of the housing boom in the country. More than two thirds of the mortgage had been backed by securities. By the start of 2008, there was approximately 16% of the outstanding prime mortgage that had been defaulted and the rate of foreclosure had risen to 7% which was far higher than the rate of prime home mortgages. The default and the foreclosure rate have continued to rise with time and at the same time this has pushed the rate of interest rate in the country. The money losses have as well been felt in other sectors and in the whole world as well. By 2006 one of the investment firm Merrill Lynch took about $800 million in assets from the mortgage oriented hedge funds which is run by its fellow banking firm Bear Stearns. The company believed that it had made the best bet on the Subprime mortgage but this would not payoffs. The funds were left with no asset. In 2006, one of the leading American Home mortgage Investment Corporations, announced that it was almost bankruptcy in the same year, Countrywide Financial which was the second leading lender in the nation also announced that it was going bankrupt. However this firm was to be saving by the Bank of America Investment which put in $2 billion to its operation. (CNNmoney.com, 2007) These huge losses and loss of investments by some of these large companies have made enormous losses in the industry. Other companies include Goldman Sachs, British Bank Northern Rock, Citigroup and others have all suffered from their real estate investment. The problem has largely been attributed to the homeowners defaulting to pay their loans than can be attributed to the flawed methods in which the mortgage was issued. It can be observed that in the US the losses were felt in the hedge fund which is a lightly regulated leveraged investment which is limited to only a few wealth investors. As we stand now the US Subprime mortgage fall has affected the important housing sector in other countries. Although this has the influential effect that the US economy many have on the world, it has become clear that it may end having more devastating effects as well. While the crisis ahs influenced other parts of the world and increase the credit crunch, the Subprime mortgage crisis in the US may eventual affect other economies as well. Conclusion Subprime crisis has been one of the most important factors that have enabled the Americans to own home. It had been providing people who are far below the credit worth to access loans to acquire home. However the Subprime industry has been rocked by crisis which has led to a high rate of defaulting for the loans. The government has contributed to the crisis by failing to make regulations in the growing industry. The borrowers have also been criticized fro taking loans that they could not pay. As the effects of the crisis bites, there is expected to be more falling out and several lending institutions may continue to be bankrupt. Reference: CNNmoney.com, 2007, Merrill sells assets seized from hedge funds, Retrieved from Jenny, S. 2007, Subprime default to soar and hurt lenders, Oxford University White, R. & Hirschhorn, S. 2008, What the Subprime crisis means for business, Metropolitan Corporate Review, 2008 Rick, B. & Ruth, S 2007, Subprime Debacle Traps Even Very Credit-Worthy, Wall Street Journal, 2007 Blundell, A. 2008, The Subprime crisis, Financial Market Trends, Vol. 2, Issue 94 Berlau, J. 2007, Confronting the Subprime crisis, Competitive Enterprise Institute, Washington DC. Tempus, N 2007, Diversifying experience shakes off the fallout from the Subprime crisis. Times Online, July 2007 Karen, M 2007, Foreclosing on opportunity and the state law on mortgage credit, Credit Review, May 2007 Morgenson, G 2008, Home loans becoming a nightmare, The New York Times, March 2008 Austan, G 2007, Irresponsible mortgages opens door to have many excluded, Economic Scene, The New York Times, May 2008 http://money.cnn.com/2007/06/20/news/companies/bear_stearns/index.htm on 10th August 2008 Read More