Subprime Mortgage Crisis
According to a study conducted by a nonpartisan research & policy organization called Center for Responsible Lending, more than two million people who had taken subprime mortgages are facing foreclosure this year & about 20% of such mortgages drawn between 2005 & 2006 have been projected to fail!Other disconcerting news is that few subprime lenders have filed bankruptcy this year and many others closed last year. Some observers are putting the blame on predatory lending & ignorance on borrower’s part about terms & conditions of the mortgage they were taking.In this article we will try to look at the causes because of which this crisis developed and how it is affecting us.
Subprime mortgages are available for consumers with poor credit records or those who cannot prove their income which would be required for making monthly payments on the loan. This type of loan is considered risky for lender as well as borrower due to combination of bad credit profile, high interest rate on the mortgage and unclear financial position of loan applicant.It all started from late 2003 through early 2004. At that time Federal Reserve Board had started encouraging lending institutions to introduce new adjustable mortgage rate plans in the market.Meanwhile in this same time period Federal Reserve Board raised mortgage rates from 1% to 5.25%, making ARMs beyond the reach of borrowers. And those who had taken ARMs during that period are now having problems continuing their mortgages and are facing foreclosure.As many mortgages started going into default lenders were not able to recoup their losses. It resulted in severe credit crunch and threatened solvency position of numerous private banks & lending institutions.The subprime crisis has been a mix of:
- Predatory lending by subprime lenders.
- Low level of effective government oversight.
- Wall Street investors not verifying strength of portfolios before backing subprime mortgage securities.
- Borrowers over-stating income on mortgage applications to qualify for loans.
Major steps have been taken by world central banks to stabilize the current situation –
1. Central banks all over the world have started coordinated efforts to increase liquidity of their currencies. This liquidity would thus result in stabilization of foreign exchange rates & stem further fall in US dollar and it being sold off. These steps would help prevent significant global consequences a run on US dollar would cause.
2. Federal Reserve has injected 43 billion USD, while European Central Bank & Bank of Japan has injected 191 & 8.4 billion USD respectively to stabilize the situation.
3. To make sure that Federal Funds rate trades at the target rate Fed has injected $30 billion and a further $38 billion for lowering the effective Federal Funds rate.
4. Federal Reserve has cut the discount rate by half a percent (from 6.25% to 5.75%) & left federal funds rate unchanged to help stabilize financial markets.
5. Federal Reserve has added another $31.25 billion in temporary reserves to keep credit markets from drying up. These reserves are temporary loans for banks which use securities as collateral.
Apart from these steps taken by central banks, House & Congress are both considering bills to regulate lending practices. Regulators are also looking at rating agencies which may have played a role in rating securitization transactions containing these subprime mortgages.
Many economists think that this current situation can take the economy into recession as now lenders are starting to tighten their standards, thus making it difficult for consumers to get loans.
Contrary to belief of such economists, Ben Bernanke, Chairman, Federal Reserve has clearly told Congress that crisis in subprime mortgage sector has certainly caused severe financial trouble for numerous individuals & families, but it will not have an affect on overall economy.
Find about mortgage interest deduction in our next article here: