Many factors contributed to the collapse of the US subprime market in 2007. In this article we have shown how the borrowers, financial institutions, mortgage brokers, underwriters, credit rating agencies and many other factors have contributed to the failure of the US subprime market:
Borrowers and the US subprime failure
The housing bubble in US was a consequence of the of the escalating house prices by 124% during the period 1997 and 2006. The failure of the subprime market started with the existence of an entrepreneur who realised that he could profit by the demand supply gap that existed between the people who wanted buy a house and financial units that could finance them.
The problem was that loan was available to the common people at very high interest rates due to their low credit worthiness. Here came the role of the entrepreneur.
He could borrow at a low rate of interest from the investment banks possessing a higher credit rating. This money he lends at a higher interest rate to those who want to purchase the house. An important feature of such loans is that they can be refinanced.
Another feature is that in the starting two to three years the intrest rates are low and kept at a fixed level. With time the intrest rate become volatile and tend to shoot up. Refinancing is not a big deal when the real estate market is undergoing a booming phase. For the borrower the cost of loan is never too high since he can refinance his loan at an interval of two years. The entrepreneur, on the other hand, issues mortgage backed securities in order to securitise his loans.
The investors are also paid a certain amount of money in the form of interest. The money that is generated from the loan securitisation is used by the entrepreneurs to repay back the loan taken from the investment banks. The payment of interest as well as the principal amount to the investors comes from the installment payments of the home loan borrowers. The problem arises when the interst rate rise abnormally high. The immediate effect is the fall in the price of real estate. The home loan borrowers are in a fix. They are unable to pay the high installments and at the same time it becomes difficult for them to refinance due to the falling real estate prices. With the default of the borrowers the the interest payments that rae given to the investors are not met. In such a case they turn back to the entrepreneur and he has no option but to file a bankruptcy. This is how the inability on the part of the borrowers to repay back the loans led to the failure of the US subprime market.
Mortgage brokers and the failure of US subprime market
The mortgage brokers do not lend money out of their own pockets. The more riskier loans they are successful in selling, more will be the commissions earned by them. According to the Chairman of Mortgage Brokers Association the mortgage brokers definitely benefited from the house loan boom in US but they never involved in checking the repaying capacity of the borrowers.
Government and the failure of the US subprime Market
There is one school of thought that holds the government policy responsible for the failure of the US subprime market. By the Community Reinvestment Act the banks are forced to lend to individuals who have a low credit rating.
Central banks and the fall in the US subprime market
The Central Bank shows less concern for avoiding asset or housing bubbles. They have not till date attempted to identify the asset bubble or formulate any proper monetary policy to deal with the existing situation.