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How Sub Prime Loans Led To A Global Recession

Powerful Essays
Sub prime lending means making loans that are in the riskiest category of consumer loans. It is lending to borrowers with bad credit, limited debt experience, a history of missed payments and recorded bankruptcies. With a subprime loan there’s a higher risk that the lender doesn’t get paid back, and so a higher interest rate is charged due to the greater risk for the lender.

Between 1997 and 2006, the price of the typical American house increased by 124%. Many people assumed that this trend of increasing housing prices would persist.

In 2000, interest rates were lowered to try and ward off recession and get the economy going. Lowering interest rates means injecting additional money into the economy. Also, in the years leading up to the start of the crisis in 2007, significant amounts of foreign money flowed into the U.S. from fast-growing economies in Asia and oil-producing countries. This inflow of funds contributed to the lower interest rates which lead to inflation and the dramatic increase of housing prices. There was now a lot more money in the economy, and so, the market for pretty much all goods inflated and demand for all goods increased as people had enough money to satisfy their demands.

There was a lot of additional money floating around in the economy. The banks that lend this money out were looking for newer more innovative ways to lend the money out and earn additional revenue from it. One idea was sub prime lending. As I said, sub prime loans are the riskiest type of loans because they’re given to people who are less likely to be able to pay off the loans. Because of this, high interest rates were charged for sub prime borrowers. Banks expect a high number of defaults and foreclosures with sub prime borr...

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...e house). In addition, minimum down payments should be set up for home mortgages of at least 10% for example and banks should ensure that borrowers have a flow of income.

• Simon Johnson: Break-up institutions that are "too big to fail" to limit systemic risk, which is the risk that one market participant’s failure will have negative effects on other participants due to the interlocking nature of financial markets.

• Eric Dinallo: Ensure any financial institution has the necessary capital to support its financial commitments.

• A. Michael Spence and Gordon Brown: Establish an early-warning system to help detect systemic risk.

• Nouriel Roubini: Nationalize insolvent banks.

• The rating processes can be re-examined and improved to encourage greater transparency to the risks involved with complex mortgage-backed securities and the entities that provide them.
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