Macroeconomic Paper - Essay Example

Subprime: A Predictable Surprise The article which I am going to discuss today appeared in Business Week on December 17, 2007 and is written by Michael Watkins1. This article is basically about the phenomenon called predictable surprise and is being applied on the subprime crisis that emerged recently in US and engulfed various other developed economies also.Sub-Prime lending typically has been characterized as lending at relatively costly interest rates and fees to credit impaired or otherwise high risk borrowers.

” (Lax, Manti and Raca). Subprime loans are among the newly popular mortgage products, such as interest-only loans, for people with strained budgets, including first-time buyers. Homeowners increasingly use them to refinance and consolidate household debts when their credit scores fall in the wake of bankruptcy, high medical bills, or other setbacks. (Blanton). It is generally believed that the subprime borrowers emerge due to lack of the good credit history on their back and since there number grew historically therefore banks and financial institutions by spotting the opportunity started lending to them at higher interest rates due to the perceived risks involved in these subprime loans.

Having defined what subprime mortgages are, this article has articulately put forward the theory of predictable surprise in order to discuss the clues which the economic trends in US suggested specially after the collapse of dot com companies during 1990s. Due to the lack of policy attention by the government especially FED, the lowered interest rates in the economy created an inflated housing markets which thrived on the equity cushion created through the artificial and speculative surge in the market.

The consequences of such behavior helped create a predictable surprise in the economy. Article has further discussed the role of securitization and its impact on the economy as a whole. The securitization through financial derivatives produced the results which authors predicted in their theory of predictable surprises. With the advent of innovation into the financial industry, Financial Derivatives provided a very efficient and effective tool to the financial managers to effectively manage these kinds of risks.

However, financial derivatives itself are considered as detrimental if their use is made in more superficial way. Banks, in order to recoup the lost liquidity drained into the subprime mortgage loans have securitized them against the payments and real estate properties offered as securities in those mortgage loans. The process of securitization works in double way. Banks rely on the cash flows generated through the repayment of these subprime mortgage loans to pay off their obligations on those securitized instruments issued by the financial institutions.

The problem arises when the subprime borrowers started to default on their obligations hence creating a mismatching in the liquidity positions of the financial institutions. Since most of the financials institutions have already securitized their mortgage portfolio therefore, in order to avoid being defaulted on their payments to the bond holders of those securitized loans, they divert their normal cash resources to the payments to be made to those bond holders. Since the normal and routine liquid resources of the financial institutions go to the repayments of those bonds therefore they find themselves short of liquidity hence a credit crunch in the economy emerges as a result of this.

Though financial institutions have the legal rights of the properties mortgaged against those subprime loans however under distress conditions, these mortgages may not fetch the desired level of price so the recoupment of those loans do not seem to be working under these conditions also secondly financial institutions are in the business of lending and it is not their job to sell off the recouped homes therefore a double edged sword like problem emerge for the financial institutions for their subprime mortgage portfolio.

The economic impact of the economic phenomenon which is being discussed in the article has been huge and is increasing in the exponential growth. It is largely believed that the outstanding in the subprime mortgage market only in US has been around 1.3 trillion US dollars. (Ramady) . Such huge amount of markets carry over a lot of risk posed not only to the US economy itself but also to the other parts of the world since credit crunch in US seems to be flourishing in other parts of the world too.

There has been a drastic increase in the growth of the subprime market in the United States since 2003 as these loans accounted for almost one fifth of the mortgage market and an estimated 15% of the outstanding mortgages in 2006. (Reserve Bank of Australia). In addition, between one half and two thirds of sub-prime loans are adjustable-rate mortgages (ARMs), compared to less than one quarter of prime loans. Most sub-prime ARMs have an initial two-year period in which the interest rate is fixed at a relatively low level before being adjusted at fixed intervals thereafter in line with changes in floating market rates.

However, what policy measures the government need to take more legislative efforts to put a check on the finance companies in terms of their risk appetite. Though BASEL II is in place but there is also a need to develop local regulations like SOX to better control the economic impact of such predictable surprises.Works CitedBlanton, By Kimberly. "Dark side of subprime loans Mortgages for those with bad credit leap in popularity despite high foreclosure rate." 3 August 2005. boston.com. 07 July 2008 .

Lax, Howard, et al. "Subprime Lending: An investigation of Economic Efficiency." Housing Policy Debates 15.3 (2004): 533-571.Ramady, Mohamed A. "US Subprime Market Tsunami — The Fed Is Worried." 9 April 2007. Arab News. 07 July 2008 .Reserve Bank of Australia. "Financial Stability Review." March 2007. Reserve Bank of Australia. 07 July 2008 .