Mar 26, 2018 in Economics

Introduction

The growth of any economy of any country in the world is very much determined and affected by the correlated growth or otherwise of the sector industries that are present in that particular country. In other words, the performance of the different industrial setups in these nations culminates into how the economy of that particular nation will behave.

The subprime mortgage crisis that rocked the United States of America economy in the year 2007 led to a widespread financial crisis and a very profound deterioration of the economy of United States. According to Demyanyk and Hemert (2008), the crisis was characterized by subprime mortgage delinquencies and foreclosures. There was also a massive degeneration of the value of securities that were backed up by those mortgages.

The uniqueness of this crisis is that it almost led to the undoing of the country that is termed as having one of the strongest economies in the globe. How could this have happened?

The paper will aim at answering the following research question: what was the cause of the subprime crisis in the USA in 2007 and how did it affect the economy of the country and the world at large?

This will be the first time that the researcher is being engrossed in this research and as such, no much headway has been made. However, from the preliminary research and background checks done on the topic the research expects to find the following;

  • That banks were the ones who were the main players in this crisis
  • That loans and financial assistance were being offered without collaterals from banks
  • The supply of houses exceeded the demand and the incomes of households didn’t rise to match the increased inflation and hence people could not pay their mortgages.

Causes of the Subprime Mortgage Crisis in the USA in 2007

A number of factors had led to the eruption of the subprime mortgage crisis of 2007. Some of these factors are discussed in the following paragraphs.

The housing market had seen a very huge boom by the year 2004. House ownership in the United States had increased considerably to almost over 70%. This was mainly made possible through the massive subprime lending that saw the demand for housing in the country soar considerably (Turnbull et al 2007). This demand increased the prices of the houses with houses being valued at over 100% by the year 2007. The price increment of these houses led to the house owners taking up a second mortgage on the houses. As the prices of the houses increased, the consumer savings reduced and household debts increased proportionately.

The easy access to credit facilities from the banks led to an increased building of houses all over the country. The borrowers believed that the prices of the houses would keep on increasing and encouraged many of the borrowers to acquire adjustable rate mortgages (ARMs). Borrowers could borrow money at a slightly lower rate than the normal market rate for a specified period of time.

When this period of adjustable rate mortgage (ARMs) was exhausted, these borrowers found themselves not being able to adjust to the high rates of repayments that were demanded from them. This went hand in hand with a declining price of the houses since the supply had exceeded the demand (Bianco, 2008). Refinancing was practically impossible at this declining market.

Lack of refinancing led to many defaults. Borrowers didn’t have the money to repay loans and they started selling them off. This led to an overall lowering of the prices of these houses and further lowering the equity of these homeowners. The decline of the payments from these mortgages led to the collapse of prices of the securities that were mortgage related (Shirai, 2009). Banks were the major losers here as foreclosed houses could not find a market or were bought at a much depreciated value. This almost led to an economic crisis in the country.

In this market, the speculation was widespread. There were so many speculators in the market that people actually made money when the houses were being constructed and sold them without even ever having lived in them. Then in 2006, the speculators left the market and this is where trouble started. Investments in the real estate fell abruptly and prices of the houses were devalued. There was massive default all over the country with people not being able to sell houses they had bought by financing and refinancing through mortgage. Eventually, this led to a mortgage crisis.

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The banks and other financial lenders contributed greatly to this crisis. There was a great shift from prime mortgaging to subprime mortgaging. Mortgage loans were given to people who had no record of credit worthiness. This is a highly risky market. The lenders offered the potential borrowers very highly-risky loan options and incentives. Some of these options are;

  • The borrowers didn’t need to have employment. They just had to prove that they had an account in the bank and money
  • The ARMs was another high risk option where the lenders were induced to borrow through paying a relative low interest rate on the loan for some time and then paying the normal repayment rate after the period was over

However, with time, according to Weaver (2008), the households were not capable of paying back those loans because even if the prices of the houses increased considerably, the debts also increased with the incomes of these households remaining constant. And when the decline started to occur, majority of these borrowers defaulted on these loans.

A number of government bills were passed and these led pressure on this industry. The congress passed bills that allowed non-chartered housing creditors to offer ARMs. There were also many policies passed by the government to promote affordable housing and this could have been a major contributor to the collapse of the market. When the decline and foreclosures started, the government did not do much to prevent these widespread foreclosures from happening and the banks took advantage of that.

By the year 2006, over 45% of the American adults had debts from financial institutions that were pulling them down. According to Turnbull et al (2007), many adults in the country were holding credit cards and living on the brink of financial collapse. When banks started dishing out mortgage loans to these people, they were also offering personal credit to household at the same rate. When the prices of the houses increased considerably as a response to the demand, the wealth of the household was still pinned down by high debt levels and stagnant income levels.

Afterwards, when the prices declined, many households found themselves at a tragic position, being unable to balance the mortgage loans repayment and the debts that were looming everywhere. This resulted into widespread defaults and foreclosures.

The mortgage crisis in the United States of America in 2007 led to a number of consequences and the impact was most felt, inarguably, in the economic setup of the country. The consequences that resulted from this crisis are outlined in the following paragraphs.

Measures to Control the Adverse Effects of Crisis

About one year down after the crisis, the economy of the USA was hard hit. According to Bianco (2008) majority of the people who had been lured into acquiring mortgages from the banks and other financial institutions lost more than 25% of their total worth. Others were still struggling to balance out their worthiness out. There were very many foreclosures and the economy lost over 8 billion dollars from the savings, investment and pension assets in the country.

The mortgage-related securities market received the hardest hit. The prices of stocks dropped and slumped overnight leading to massive loss. This was as a outcome of the lack of confidence in the real estate market by the investors. The investors pulled out of the mortgage market preferring to invest their money in other commodities market such as the financial derivatives and the financial speculation markets. After the collapse of major players in the mortgage market like the Lehman brothers in 2008, investors withdrew their money from the banking and financial institutions very fast that they led to the collapse of the mortgage industry.

There was a considerable rate of imbalance between wealth and income among individuals in the country after the crisis. People found themselves holding real estate that was practically worthless. The deterioration of prices in the real estate industry and the stagnation of the income, coupled with the increased household debts let to a huge imbalance of wealth and income.

The USA, being a super power, has always had a major connection and contribution to the world economy. The near collapse of the economy following this crisis in 2007 led to a stumble of the world economy. Business relations with the United States of America were drastically affected, resulting into loss of billions of dollars.

Households who were caught up in this wind and with no money to bail out found themselves at the mercy of the banks that devoured them. Foreclosures were a common site. People lost money, homes and were still chained to debts. There was a general loss of confidence in the banking systems, the mortgage market and the government’s ability to rectify such kinds of situations (Lim, 2008).

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The government has effected a number of regulations that were meant to bring this issue of the mortgage crisis to rest. The US congress in 2009 approved some of these regulations and these are discussed in the ensuing discussion.

  • Firms are required to have a stronger base on capital and liquidity and this should be regulated by the concerned body.
  • Firms that are not capable of meeting the standards set by these boards are allowed to dissolve in an orderly manner without hope of government bail out
  • The taxpayers should not, in any way feel the blunt of the loss arising from the misconduct of these financial institutions
  • The federal deposit insurance commission (FDIC) should be expanded to incorporate even the non-bank financial institutions
  • The Federal Reserve is to be tasked with the application of checks and regulations to ensure that banks and other non-bank financial institutions follow the requirements stipulated by the federal reserves

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