The subprime lending crisis that occurred in the United States around 2006 is unique in history as the first time a plunge in the overall economy was driven by a credit crunch in the non-banking sector of finance (Bianco, p. 3). A new, specialized, unregulated, mortgage lender emerged offering high-risk loans and incentives for buyers. ARMS, or adjustable rate mortgages, offered “teaser rates” that were very low, temporary introductory rates that would sometimes double the monthly mortgage payments after the initial period was over. Interest-only loans came with the teaser to pay only the lower interest vice any payment on the principle. The lenders also institutes “no doc” and electronically-processed/signed loans mitigating any need to verify income-to-debt ratio on loan applications. These and other lax standards, coupled with the overvalued, unsustainable housing market led the housing bubble to burst. Once the housing market made a correction and the valuation of housing dropped as much as 50 percent (Bianco, p. 6), the subprime mortgage industry collapsed causing multitudes of home foreclosures.
Why a borrower would take out such a loan is easy to understand–temptation. The lures of teaser raters and incentives appeared to be a “Golden Opportunity” and the adjustments upward could be ignored as that would not happen until in the future. Why the lender would offer such teasers and incentives is also easy to understand–the enormous profits (Watkins, p. 366). With little thought regarding long-term consequences of subprime loans, both the lender and the borrower inked the loan setting up a formula for disaster (Bianco, p. 2-8).
The consequences resulting from the subprime lending were enormous and wide-spread. People were defaulting on loans and mortgage lenders were foreclosing. People had to vacate the homes and leave them empty. The lenders who foreclosed were ill-prepared to maintain the homes thus making the situation ripe for squatters to move in and cause damage. The lawns became ragged and overgrown impacting not only the value of the foreclosed home but also the value of homes throughout the neighborhood. This was not an isolated incident as many homes were being foreclosed throughout the country causing even more devaluation of homes.
As the situation worsened, financial leaders tightened loan requirements thus causing more borrowers to be unable to qualify for loans for a house or to build one. With fewer loans approved, home builders, carpenters, electricians, pipe fitters, carpet installers, and a host of others found their incomes constrained. Realtors and closing agents also felt the impact as the market declined. The lenders experienced layoffs, bankruptcies, and the loss of hundreds of billions of investment dollars (Gilbert, p. 89). The downfall of subprime mortgage lending, coupled with the housing devaluation from the market correction, made some homes worth less than the loan on them.
The above are the risks the lenders and borrowers each willingly accepted at the beginning. In the end, it took “injections of money and reduction of interest rates by the Federal Reserve Bank ” (Gilbert, p. 89) and help from the Federal government to stabilize the situation, albeit slowly.
The leadership role in this debacle needs examining.