The Risk Management Aspect of the Sub-Prime Debacle

The Risk Management Aspect of the Sub-prime Debacle

The Risk Management Aspect of the Sub-prime Debacle

Subprime refers to a category of borrowers who have a poor credit history.  For these individuals to give loans, lenders use a statistical analysis to access their credit worthiness to determine how much loan the person qualifies to get, which is referred to as subprime loan. The loan carries a lot of credit risk, and it involves a lot of high-interest rates.  The reason for a rise in the interest rates is that the probability of defaults to occur is high (Acharya & Richardson, 2009). The subprime debacle, therefore, is the sudden decline or failure of the subprime loan extended to the borrowers who have a poor credit history leading to some embarrassing situations (Acharya & Richardson, 2009).  The decrease in subprime loans can be attributed to a financial lending institution, borrowers, government, and law regulators. In most cases, a subprime debacle occurs in mortgages. Subprime mortgages revolve around those borrowers with a poor credit history that cannot afford to buy a home, but even those with good credit history apply for the loan. In the US, African-Americans and the Hispanics are likely to encounter a high rate of poverty now as compared to a decade ago, which can be linked to the racial segregation where the minority groups is denied to access to subprime loans (Acharya & Richardson, 2009).

Back in History

A few decades ago, most of those developed nations were experiencing an increase in the housing prices. The collapse of this housing bubble was evident in the year 2007-2008, which was a worldwide phenomenon.  However, in the United States of America it was experienced differently as compared to other nations.  The new Millennium in the USA started with a strong and significant housing market (Acharya & Richardson, 2009). During this time, many people had turned their preferences to invest in real estates that were specifically for their homes. In 2004, there were only a few prospective buyers who could not purchase their homes by then (Raashid, Rasool & Raja, 2015). These people were referred to as subprime borrowers since they could only afford to pay the down payment. In effect, it resulted in the lending investors concentrating on those subprime borrowers. They did this by eliminating the down payment to attract as many borrowers as possible but gave them loans with high-interest rates. Eventually, it led to the development of a subprime lending bubble. Since they did not expect them to pay back, the mortgage insurers acted as the security to these lending companies.

In the past decades, most of the mortgages were given to those with a poor credit history. The banks were lending more to these subprime borrowers, which resulted in a massive buying of homes by those borrowers leading to a rise in the price of those properties (Acharya & Richardson, 2009). These default rates were low at the beginning though there were mortgage payments for the houses.  Initially, the banking industry could sell the mortgages, which could enable them to recover the loss of the defaults and for the mortgages payments that the borrowers did not pay (Raashid, Rasool & Raja, 2015). Afterward, things changed when these default rates started rising rapidly especially for the subprime borrowers.  At this time, the number of mortgages that were not paid was increasing steadily. It resulted in the banking industry and other lenders encountering a surge in the number of houses. Consequently, it led to a decline in the real estate prices, which increased the interest rates on the loans. Ultimately, it caused a decrease in economic activity, and it was, therefore, named as subprime mortgage crisis. To overcome this subprime crisis,  the Federal Reserve enacted the subprime debacle with a goal of lowering the interest rates following the bursting of the sub-prime lending bubble (Raashid, Rasool & Raja, 2015).