key term - Subprime mortgage crisis

Definition

The subprime mortgage crisis refers to a financial crisis that occurred in the late 2000s, primarily resulting from the collapse of the housing market due to an excessive number of high-risk mortgage loans granted to borrowers with poor credit histories. This crisis was characterized by rising mortgage delinquencies and foreclosures, which ultimately triggered a global economic downturn, significantly impacting financial institutions and economies around the world.

5 Must Know Facts For Your Next Test

1. The subprime mortgage crisis began in 2007 and peaked in 2008, leading to significant losses for banks and financial institutions globally.
2. Subprime loans were often offered with low initial interest rates that later adjusted to much higher rates, making it difficult for borrowers to keep up with payments.
3. The housing bubble burst when home prices began to decline, leading to many homeowners owing more on their mortgages than their homes were worth.
4. Government intervention included bailouts of major financial institutions and efforts to stabilize the housing market through programs aimed at preventing foreclosures.
5. The crisis highlighted the dangers of predatory lending practices and inadequate regulatory oversight in the financial industry.

Review Questions

• How did the characteristics of subprime loans contribute to the crisis, and what role did they play in the overall economic downturn?
  • Subprime loans were often characterized by high interest rates, adjustable-rate terms, and minimal verification of borrowers' ability to repay. Many borrowers took these loans without fully understanding the long-term implications, leading to a spike in delinquencies when payments increased. This surge in defaults contributed significantly to the collapse of mortgage-backed securities, causing widespread financial instability and a global economic downturn as banks faced massive losses.
• Discuss the impact of mortgage-backed securities on the financial institutions involved in the subprime mortgage crisis and how this affected global markets.
  • Mortgage-backed securities were considered low-risk investments until the underlying mortgages began to default at alarming rates. Financial institutions that heavily invested in these securities suffered devastating losses as their value plummeted. This not only led to bankruptcies of major banks but also resulted in a lack of trust in financial markets worldwide, causing liquidity shortages and further exacerbating the economic crisis.
• Evaluate the effectiveness of government responses to the subprime mortgage crisis and consider alternative measures that could have been taken.
  • Government responses included bailouts for major banks and initiatives aimed at stabilizing the housing market, such as foreclosure prevention programs. While these measures provided short-term relief, they faced criticism for not addressing underlying issues like predatory lending practices and insufficient regulatory frameworks. An alternative approach could have involved stricter regulations on lending practices before the crisis began, as well as providing greater support for consumer education on mortgages to empower borrowers to make informed decisions.

Related terms

Mortgage-backed securities: Financial instruments created by bundling together a group of mortgages and selling shares of that bundle to investors, which became highly risky during the subprime mortgage crisis.

Foreclosure: The legal process through which lenders reclaim property when borrowers fail to meet their mortgage obligations, which surged during the subprime mortgage crisis.

Credit default swap: A financial derivative that allows an investor to 'swap' or transfer the credit risk of fixed income products, which played a key role in the financial instability during the crisis.