Thursday, December 23, 2010

The Effect of Subprime Mortgages on the Economy

Ok, so as some of you know, I am an Honors student in the University of Tennessee at Martin (GO SKYHAWKS!). As part of the Honors program, we have to go to small seminars and large academic talks and write a big paper on one of the topics discussed. This was my paper that I wrote my freshman year, in it's entirety. This is not to be used for anyone else's classes, papers, or any other such thing. I am putting it out there for the sole purpose of informing people of what I found and what I discussed. 

On February 4, 2010, Julie Stackhouse of the Federal Reserve Bank of St. Louis came to the University of Tennessee at Martin campus to give a seminar on the economic recession and recovery in the United States of America. One of the main points Ms. Stackhouse spoke about was subprime mortgages, also known as predatory loans. These loans let less than credit worthy people get loans at lower rates initially, but with the increasing interest rates after a few years, the people could not make payments on their mortgages, causing foreclosures, which put stress on the banks, causing a burst of the housing bubble and a recession to occur. I have chosen this topic to research further and expand on. The subprime mortgages played a major role in the downturn of the economy.

To understand the harm subprime mortgages caused, one must first determine exactly what they are and who received them. Most subprime mortgages were “given to borrowers with credit scores of 620” (Lee), and as low as 600 by some sources (Gerardi, et al.). Most of the loans, “about 80 percent, [had] adjustable-rate mortgages” (Lee) and required little or no down payment. This in and of itself was a problem because that low of a credit score indicated that they had problems making payments on loans, had financial problems in the past, and overall tend to be bad risks when it comes to giving credit. It also meant that the person seeking credit did not have to have much money to back up the loan for the down payment, making it easier still for a bad risk person to receive credit. If the credit rates increased, they would almost surely default on the loans. Also, some believe that “minority borrowers were steered into subprime loans in some cases when they might have qualified for cheaper conforming loans or…were given subprime loans that had fees or rates that were too high” (Haughwout, Mayer, and Tracy). Other groups of people who were exploited were “immigrants, the elderly” (“Senator Dodd: Create, Sustain, Preserve, and Protect the American Dream of Home Ownership”), and other groups on fixed incomes. However, a majority of the “subprime borrower[s] [were] not someone buying a house, but someone refinancing” (Lee) and did so to pay off credit card debt. The way borrowers were misled by the creditors and the groups that were preyed upon by the banks increased the number of predatory loans, which would harm the economy later.

The subprime mortgages started being issued to make money quickly. “Interest rates were relatively low in the first part of the decade,” (Crouhy, Jarrow, and Turnbull) fueling the mortgage industry and the housing industry simultaneously, along with other related businesses, such as logging and making windows. With loans easier to get, people who previously could not get credit suddenly could, allowing them to buy houses with low interest rates. They could achieve at least part of the American dream of owning a house with low monthly payments and a low interest rate. The subprime mortgages were attractive to borrowers because they could pay “low teaser rates over the first few years, often paid no principal, and could refinance with rising housing prices” (Crouhy, Jarrow, and Turnbull). This allowed the consumer to get more money to buy commercial and luxury things, pumping money into the economy, allowing other businesses to grow. The increase in the number of people with the ability to buy a house spurred the housing industry, seen firsthand in my hometown of Atoka, Tennessee, where from the time I moved there in 2004 until the bursting of the housing bubble in 2007, the number of new houses being built seemed to increase every year, with cotton and corn fields being sold to contractors to be converted into subdivisions. Businesses such as tiling, home improvement, and other related industries started booming alongside the housing industry, with my neighbor, who tiled floors for many years, making remarks about how he had never been so busy in his entire life and he had never made so much money so fast. The loans were attractive to lenders because they “offer[ed] higher yields than standard mortgages” (Crouhy, Jarrow, and Turnbull), allowing investors to not only make more money, but issue more of the predatory loans, creating a constantly repeating cycle. This cycle also drove up the prices of houses, due to the high demand for houses, forcing prospective home buyers to borrow more money. If some of the investors “had…known the future trajectory of home prices, they would have predicted large increases in delinquency and default” (Haughwout, Mayer, and Tracy), and would not have made as many subprime loans, if any at all, and a lot of the crisis could have been avoided. With the incentives of banks and other creditors to make a lot of money off the predatory loans, and the desire of the consumer to become a home owner and move up in status in the community, the vicious cycle was perpetuated not only by greed but by the desire to look good and acquire a higher social status.

A domino effect caused the credit crisis and added to its severity. In 2005 home prices started to “decline in price, [and] people who refinanced, especially those who did so with variable interest rates, suddenly had homes valued at much less” ("What Caused the Subprime Mortgage Crisis?"). It is going to take a lot to improve the credit situation. There has already been “more than $8 trillion [committed] to bailing out banks” (Taylor), yet the banks are hesitant to give out loans (Taylor). Some statistics show that “as many as 10 million families will lose their home before this crisis is resolved” (Kuttner), dragging down the economy even more. One problem that is being addressed is “the regulatory oversight for non-bank mortgage institutions was all but nonexistent” (Taylor) during the boom years of the housing bubble. The CRA Modernization Act of 2009 is a proposed law that would strengthen the existing Community Reinvestment Act to make it more effective and expand CRA's purview to financial institutions other than banks, and had it been enacted before this crisis occurred, many of the unethical and unsavory lending practices that caused the situation would not have occurred at all (Taylor). Some stimulus programs such as Cash for Clunkers, bank bailouts, and automotive company bailouts have done some good in improving the economy and restoring employment so that people may retain their houses. It will be a long time until the effects of this crisis have worn off and continuous growth can occur again.

There were many factors that caused the downturn in the economy, but the subprime mortgage crisis was probably the single largest contributor to the recession. The extending of credit to people with less than desirable credit scores was probably the first mistake investors made. The fact that the loans were misleading in that interest rates started low, had adjustable interest rates, and required little to no down payment on the loan only worsened the situation. The borrowers were mainly refinancing their homes, and when their homes became worth less than they were paying on, the market was flooded with houses, driving the prices down further. Banks made the loans because they promised a higher yield than traditional loans, more of them could be made, and the money off the predatory loans could be made quickly. Other businesses prospered from the refinancing of homes because consumers were buying luxury items or improving their newly purchased house. Greed and lack of oversight on the part of the creditors and desire for more and better social status on the part of the consumer allowed the subprime loans to be continued to be made. The same businesses that prospered from the booming housing industry also suffered because of it, increasing unemployment as more and more businesses either reduced their workforce or went out of business completely. As unemployment increased, more defaulting on loans occurred, hurting banks and other creditors more, along with the economy. Legislation and government sponsored programs have done some good in improving oversight and the economy as a whole, but it will be a long time until we see a complete recovery. These predatory loans greatly hurt the United States economy.

Works Cited

            Crouhy, Michel G., Robert A. Jarrow, Stuart M. Turnbull. “The Subprime Credit Crisis of 2007.” Journal of Derivatives 16.1 (2008): 81-110. Business Source Premier. Web. 2 March 2010.

            Gerardi, Kristopher, Andreas Lehnert, Shane M. Sherlund et. al. "Making Sense of the Subprime Crisis." Brookings Papers on Economic Activity (2009): 69-159. Project MUSE. Web. 2 March 2010

        Kuttner, Robert. "Reforming Credit." The American Prospect  20.6 (2009): A2-4. ProQuest Social Science Journals. ProQuest. Web. 2 March 2010.

        Taylor, John. "Reversing the Damage. " The American Prospect  20.6 (2009): A24-27. ProQuest Social Science Journals. ProQuest. Web. 2 March 2010.

            Haughwout, Andrew, Christopher Mayer, Joseph Tracy. “Subprime Mortgage Pricing: The Impact of Race, Ethnicity, and Gender on the Cost of Borrowing.” Brookings-Wharton Papers on Urban Affairs (2009): 33-63. Project Muse. Web. 2 March 2010.

             Lee, Mara. "Subprime Mortgages: A Primer : NPR." NPR : National Public Radio : News & Analysis, World, US, Music & Arts : NPR. Web. 04 Mar. 2010. <>.

            "What Caused the Subprime Mortgage Crisis?" WiseGEEK: Clear Answers for Common Questions. Web. 04 Mar. 2010. <>.

"Senator Dodd: Create, Sustain, Preserve, and Protect the American Dream of Home Ownership | U.S. Senator Christopher J. Dodd." U.S. Senator Christopher J. Dodd | D-Connecticut. Web. 04 Mar. 2010. <>.

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