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Why did subprime lending become a major economic problem?

A-Level, IB
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 26 May 2023

What is subprime lending and why did it become an economic problem?

Subprime lending refers to the practice of providing loans to borrowers with low creditworthiness or a high risk of defaulting on their loan payments. These borrowers typically have lower credit scores, limited income, or a history of financial difficulties. Subprime loans often come with higher interest rates to compensate for the increased risk.

Subprime lending became an economic problem primarily due to the following reasons:

Housing Bubble: In the early to mid-2000s, there was a significant increase in housing prices in many parts of the United States. This led to a belief that housing prices would continue to rise indefinitely, creating a housing bubble. Lenders became more willing to extend loans to subprime borrowers, as they believed that even if borrowers defaulted, they could recover their money by selling the property at a higher price.

Securitization and Complex Financial Instruments: Lenders bundled subprime loans into mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). These financial instruments were then sold to investors. The complexity of these instruments made it difficult for investors and rating agencies to accurately assess the risks involved. As a result, subprime mortgage risks were spread throughout the financial system, making it harder to identify and manage them effectively.

Deteriorating Loan Quality: The expansion of subprime lending led to a relaxation of lending standards, including offering adjustable-rate mortgages (ARMs) with low initial teaser rates that later increased significantly. Many borrowers were not fully aware of the potential payment shocks when their interest rates reset. As housing prices started to decline, borrowers with adjustable-rate mortgages found it increasingly difficult to meet their payment obligations.

Default and Foreclosure Crisis: As housing prices declined, many subprime borrowers found themselves owing more on their mortgages than their homes were worth. This led to an increase in defaults and foreclosures, particularly among subprime borrowers. The high number of foreclosures contributed to a downward spiral in housing prices, further exacerbating the problem.

Systemic Risk and Financial Crisis: The interconnectedness of the financial system meant that the problems in the subprime mortgage market spread throughout the economy. Financial institutions that held mortgage-backed securities and other complex derivatives tied to subprime mortgages faced significant losses. This led to a crisis of confidence, liquidity problems, and a domino effect, resulting in the collapse or near-collapse of several major financial institutions.

The subprime lending crisis, which culminated in the 2008 global financial crisis, exposed the vulnerabilities in the financial system and highlighted the risks associated with lax lending practices, complex financial instruments, and the lack of proper regulation and oversight. It resulted in a severe economic downturn, loss of jobs and homes, and had a profound impact on the global economy.

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