10/05/2015

Case Analysis
Managerial Economics

Subprime Meltdown

The case, Subprime Meltdown: in American Housing and Global

Financial Turmoil written by Julio Rotemberg focusses on the financial

difficulties that the United States faced in the early 21st century. One of the

factors leading up to the American meltdown was subprime lending. Subprime

lending during the 1990’s started to rapidly increase. The article mentions,

“lenders who specialized in “subprime” loans increased from 63 lenders in 1993

to 209 in 205”. This was detrimental to the meltdown in American housing

because lenders were lending money to borrowers that did not qualify for prime

mortgages.

The Federal Reserve stimulated the U.S economy by cutting interest rates

to historically low levels during that time period. As a result, the housing

market soared for many years. Fannie Mae CEO Franklin Raines instilled the

idea that “Housing is a safe, leveraged investment….and it is one of the best

returning investments to make.” The American people along with lenders

wanted to capitalize on what seemed to be “the American Dream”, which was to

buy and invest in owning a home. In order to capitalize on the “home-buying”

frenzy, some of these lenders extended mortgages to those who generally would

not qualify for traditional loans because of the high risk associated with their

1
poor credit history. For this reason, investment firms seemed to be eager to buy

these loans and “repackage” them as mortgage backed securities.

Many of the lenders who offered these subprime mortgages had specific

mortgages to essentially help unqualified candidates “qualify” for mortgages

that they couldn’t afford to begin with. One type of mortgage that became

popular was a “2/28.., which was fixed for 2 years and became variable for the

remaining 28 years”. These adjustable rate loans made buyers feel as though

their mortgages may be affordable, however much like in the 2/28 type, after

the two year “reset” the interest rate hurdles to a dramatically higher

unaffordable rate. The spike in monthly payments can be contributed to buyers

going into default and a major rise in foreclosures. This meltdown caused

dozens of banks to go bankrupt and even led to enormous losses from Wall

Street firms and hedge funds that marketed and invested heavily in riskier

mortgage related securities.

Ultimately, the economic recession was a result of many factors,

including the banking, housing and financial market meltdowns. The subprime

mortgage crisis resulted in the downfall of large financial institutions and

government bailouts for banks. The U.S subprime mortgage crisis was triggered

by a variety of factors, which could be contributed to the decline in home

prices. More and more mortgages became delinquent and more foreclosures

started to happen as well as the devaluation of house related securities. With

the decline in home prices, it became more difficult for borrowers to refinance

their loans. Also, because many home buyers had “adjustable” rate loans, after

2
their initial “reset”, which would set at a higher rate, mortgage delinquencies

soared. Subprime mortgages and securities backed with mortgages that were

primarily held by global financial firms, starting to lose their value. Investors

domestically as well as globally, started to pull back and reduce their

purchases of mortgages back debt and other securities as part of what seemed

to be a decline to support continued lending.