Explaining Subprime Crisis


img89Subprime mortgage was not in my financial vocabulary until last summer, when it shocked global market with unabated effect. Let’s learn more about this crisis.

What is Subprime Mortgage?

Basically it’s a mortgage for people with shaky credit, or specifically, people who is unlikely to be able to pay the mortgage. Usually it’s given to those who are seeking money to finance their houses.

Why banks (lenders) give money to those who can’t pay?

If banks are doing something, they are doing it for money. Dealing with subprime mortgage is a big risk but the interests rate for it is also high. Usually subprime borrowers will have to pay lesser interests rate for the first year and the rate climbs up for the later years. This is the time when borrowers start to have problem paying their monthly payment.

If borrowers can’t pay, won’t the banks loss their money?

Before it became a crisis, subprime was not all that bad. Banks were very vigilant in determining which people can pay or can’t pay even if they have bad credit, and the banks are very good at it(it’s their job after all). However, once real estate market was skyrocketing (just one of many reasons), a lot of people were buying and selling houses. And thus the demand for mortgage rose especially subprime mortgage (poor people want to earn extra money). Banks were getting greedier too. They thought that, even those people can’t pay once the interests rate is up, they can just sell the house with higher price and settle the mortgage. With that situation, banks became less worry about their borrowers and race against other banks to create more mortgage.

Anther important reason is that banks can sell such security (subprime mortgage) with other names that doesn’t relate to subprime at all. This is called ’repackaging’. Once it’s repacked, other people from the world can buy that security. Even the high risk is distributed in that package, the security buyers actually didn’t care because they actually earned a lot from it, at that time.

When it started to become a crisis?

I don’t know which happened first, the subprime crisis or the slowdown of real estate market. But once houses’ price started to decline, the subprime borrowers found themselves in trouble. Most of them eventually found themselves in trouble before, but now, their usual escape door – higher house price – has vanished. People started to panic and try to dump their mortgage to other people. Banks which now realize the effect of this, try to cover their loss by increasing the rate even more, forcing people who are under these mortgage to pay more and at last defaulted by the failure to pay the monthly payment.

If it’s mostly related to real estate, why the effect is so catastrophic?

We have to remember that house is the biggest investment in our life. If you have to pay more for it, you can’t buy more for clothing, food, and other necessities. This in turn, affect the retail market and other vital consumer-economic section.

There are more reasons and detail to this crisis. I explains this crisis in great simplicity and with my limited understanding and readings. Please correct me if there is any misinformation in it.For more information you can always visit wikipedia and search on google news.

Thanks to Al-Hafiz for asking.

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  1. #1 by nadlique on November 12, 2007 - 11:24 pm

    Nicely explained Irwan ๐Ÿ™‚

    Keep up the good work!

  2. #2 by squaretan on November 15, 2007 - 8:52 pm

    What a good job by our investment guru! ^^ Now i know what subprime is all about. Crisis? Hell yeah! ๐Ÿ™‚

  3. #3 by Money Minute Staff on December 8, 2007 - 3:31 am

    We think the subprime loans were a foolish thing to do, it really put people at risk uneccesarily. But what is happening now, with the credit freeze and some tax relief should help out consumers who desperately need this financial assistance.

  4. #4 by ChampDog on December 9, 2007 - 1:33 pm

    The world now is no longer as predictable as it used to be. The world now is changing very fast and what we can learn is to adopt to this fast pace environment. What majority of us predict no longer holds true in the future.

  5. #5 by Money Minute Staff on December 9, 2007 - 9:53 pm

    We think you’re right. The number one thing about subprime was greed on the part of banks and people wanting homes when they were uncreditworthy. Although, we support the U.S. credit freeze.

    http://www.moneyminuteweekly.com/

  6. #6 by (MFMS)d on December 12, 2007 - 6:51 pm

    Now I know what subprime is. Cant they use simpler word for that? Like Unpaid House/Property mortgage?

  7. #7 by ChampDog on December 12, 2007 - 7:07 pm

    It is a second change for you to borrow money if you do not qualify for the loan due to your credit history.

  8. #8 by goalcentre.com on January 9, 2008 - 1:44 am

    Government is doing all they can in US to help this crisis. If this crisis stays for a long time, then recession will come in USA. It is about time! yeah!

  9. #9 by Chromosome on July 10, 2008 - 11:31 pm

    Why the price of the properties declined at the first place?

    Can anybody enlighten me?

  10. #10 by Darin on November 13, 2008 - 10:14 pm

    How about members of congress that put pressure on banks to make these loans to people with bad credit and no down payment in the name of “spreading the wealth”?

    Plenty of blame to go around for all. However it is interesting to look at which members of congress received money from lobbists to make lending requirements go away and in many cases force banks to make bad loans.

    I agree follow the money. Sometime you have to follow the money into the governement as well as wall street.

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