What are Subprime loans and what risks do they pose to the lender and borrower?

In this part 1 of 3 , I will give a summary of the subprime fiasco.In part 2 of 3 will critique the leadership decision making role in the subprime loan financial mess.Finally in part 3 of 3 I will evaluate subprime loans with the idea of social responsibility and then compare and contrast the evolving consequences for these actions. Finally I will highlight the measures that were taken after and other measures taken so as to avoid similar crises in the future.

            An excellent outline of the subprime mortgage loan process is given by Kranacher (as cited by Muller-Kahle & Lewellyn, 2011). At the beginning, people with poor credit rating were able to acquire loans with practically no income verification. Then mortgage lenders utilized a lower tease rate to qualify borrowers so as to receive a commission. Loans were then re-bundled and sold into collateralized debt obligations (CDOs). Speculators were unable to measure the risk of these fiduciary instruments. CDOs were then bundled into loan groupings on the premise of risk level, named by credit rating agencies (CRA) as AAA to A for the best class, BBB to B for the middle class, and the riskiest were not appraised or secured by bond insurance. A significant number of CDOs were then moved to off the books special purpose vehicles (SPV) and held by Wall Street banks at a high interest rate. When the property holders with poor credit and appreciating payments started to foreclose, the worst of the CDOs were not protected and the remaining CDOs were deficiently secured by underfunded bond security, which caused enormous financial losses and dramatic collapse of many financial institutions and a worldwide financial emergency.

The breakdown of the subprime market caused the unraveling of the U.S. economy (Watkins, 2011). Investopedia defines a subprime loan as one that is tendered at a rate above prime to people who don't meet all requirements for prime rate loans (Gilbert, 2011) The U.S. Department of Housing and Urban Development, in expounding subprime lending, said the loans carry an inflated rate of interest than prime loans to indemnify for increased credit risk and one type of subprime loan is a home mortgage (Gilbert, 2011). According to the Watkins (2011), the Subprime lending mortgage market was a financial windfall for subprime lending specialists. The essential feature of a subprime mortgage was to compel the mortgagee to refinance every two or three years according to Gorton (as cited by Watkins, 2011), hence providing fees to the bank, while prepayment penalties additionally  protected creditors from efforts of homeowners to turn over their loans to obtain lower interest rates. Banks could also diversify risk, by securitizing the cash flows from mortgages. Consequently, by early 2005 major Wall Street banks were deeply submerged in the Subprime mortgage mix (Watkins, 2011).

During 2007, foreclosure proceeding begun on about 1.5 million homes in the United States. This was a 53% increase from 2000 and according to economic analysts the number of foreclosures accelerated dramatically in 2008 and 2009 (Gilbert, 2011). Subprime mortgages were less than 20 percent of all mortgages outstanding, but just over a moiety of these foreclosure initiations were on subprimes. According to Gilbert (2011) foreclosures spread to other classes of mortgages, later in the financial crisis, but the quandary originated and grew immensely colossal mainly with subprimes.

The subprime lending mess was characterized by individuals defaulting on loans, banks, and other mortgage lenders foreclosing on houses, borrowers being evicted from their homes, unkempt lawns blighting neighborhoods, and vacant house being taken over by unauthorized squatters, after they were abandoned by the borrowers and neglected by the lenders (Gilbert, 2011). Including having to write-off billion of dollars on their subprime assets, companies involved in the subprime mess had to lay-off tens of thousands of employees. Millions of people in the United States lost their homes. The fiscal instruments such as Collateralized Mortgage Obligations (CMOs) and Collateralized Debt Obligations (CDOs) that were dependent on securitized mortgages depreciated in value, and this decline substantially contributed to a freezing of credit markets, unemployment and a global economic recession                  ( Gilbert,2011).

References

Gilbert, J. (2011). Moral duties in business and their societal impacts: The case of the subprime lending mess. Business & Society Review (00453609), 116(1), 87-107. doi:10.1111/j.1467-8594.2011.00378.x

Watkins, J. P. (2011). Banking ethics and the Goldman rule. Journal of Economic Issues (M.E. Sharpe Inc.), 45(2), 363-372. doi:10.2753/JEI0021-3624450213

Muller-Kahle,M.I & Lewellyn, K.B.( 2011). Did board configuration matter? The case of US subprime lenders. Corporate Governance: An International Review, 19(5): 405–417