BLOG 1

BLOG 1: What Caused the Great Recession in the United States?

 

Possible Answer: Housing Bubble Burst causing Subprime Mortgage Crisis

 

Summary of the Concept of Subprime Loans and the Risks They Pose to the Lender and Borrower

 

During the years leading up to the Global Financial Crisis of 2008, housing prices were continually increasing. At the same time, interest rates on mortgage loans remained low. In response, presidents like Bush and Clinton wanted to give as many Americans as possible the chance to own a new home and achieve the American dream. Hence, financial institutions started offering more flexible ways of obtaining a home loan. Some of these loans were called Subprime Mortgage Loans because the borrowers were at higher risk of defaulting than borrowers who received Prime Loans. Prime loans have the lowest interest rates and best terms while subprime loans usually have higher interest rates and worse terms. Typically, a subprime loan borrower had a worse credit history and insufficient income making it harder for them to pay back the loan. Also these borrowers were only required to put down a small down-payment and sometimes no down-payment at all. Therefore, subprime borrowers posed a higher credit risk to lenders. One type of Subprime Mortgage loan was called an ARM, Adjustable Rate Mortgage. These Subprime Mortgages offered low initial interest rates called teaser rates but they were adjustable rate mortgages rather than fixed rate mortgages. The adjustable interest rates were subject to increases causing the borrower to have larger monthly payments. If the borrowers cannot make the larger payments they would have to refinance at a lower interest rate or pay-off the loan (Watkins, 2011, p. 366). The borrower was betting the interest rates would not go up. The lender was betting that even if the rates did go up and the borrower could not pay back the loan, it would not create a bank loss because since housing pricing would keep appreciating, the lender could always repossess the house and sell it for more than its loan value. The problem with this logic is that no one thought of what to do if housing prices started dropping. However, this is exactly what happened. Interest rates started rising. The interest rate on the adjustable rate mortgages started increasing. Some borrowers saw their loan payment amount double. When this happened, many of them could not repay their loans and their houses went into foreclosure. With so many houses now on the market, the increase in the supply of homes available for sale caused the prices of houses to fall. Many of these loans were securitized and bundled together with other stocks, then sold on the stock market to investors. These were called mortgage-backed securities. Some of these investors, especially foreign investors had invested in U.S. stocks relying on the triple-A credit ratings from credit rating agencies like Moody’s Investors Service, Standard & Poor’s and Fitch Ratings.   Once the housing bubble burst and the value of these stocks plummeted, investors at home and abroad lost a great deal of money. The economic effects were so severe that it became known as the Global Financial Crisis of 2007-2008. This was followed by the Great Recession of 2008-2012.

 

Critique of the Role of Leadership Decision-Making in the Subprime Loan Financial Crisis

 

           Who was to blame for the Subprime Loan Financials Crisis? Many possible suspects exist. One could say it was the lenders because it was unethical for them to make housing loans to people who had little ability to pay the money back. Also, in many cases, the banks were too lenient in their loan approval process. In some instances, as long as the borrower had a decent credit rating, the loans was approved based upon a statement of income and the borrower did not have to provide proof of income. Companies like AIG also sold mortgage protection insurance to the banks so that if the borrower defaulted, the insurance would cover the loan balance so the lenders were not really worried about whether or not the borrower was going to be able to repay.   Also the bankers knew they could eliminate all risks by getting the loans off their books. This could be done by selling the loans to securitizers. Securitizers were investment banks like Lehman Brothers, Bear Stearns and Merrill Lynch and GSE’s (Government Sponsored Enterprises) like Fannie Mae and Freddie Mac. The securitizers combined these loans with other securities and they were sold on the stock market and regulated by the Securities and Exchange Commission (SEC).

The borrowers themselves could be blamed because they should have been more prudent in handling their financial affairs. After all, no one forced these borrowers to take out the loans (Gilbert, 2011, p.99). Also some of the borrowers had been dishonest when answering income questions especially if they really needed the loan. Sometimes, the borrowers were just refinancing their homes to get a second mortgage. In other words, they were just taking the equity out of their house. Due to a period of stagnant wages and rising prices just prior to the burst of the housing bubble, many people strained themselves financially in order to keep up their same lifestyle. Credit was easy to get so they had multiple credit cards and were already burdened with overwhelming debt before they refinanced their homes. They refinanced their homes in order to obtain more money but this just put them deeper in debt while the real problem of stagnant wages and increasing inflation still existed.

 

References:
Gilbert, J. (2011). Moral duties in business and their societal impacts: The case of the subprime lending mess. Business & Society Review (00453609), 116(1), 87-107. doi:10.1111/j.1467-
8594.2011.00378.x

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