Sunday, January 24, 2010

How the subprime loan tore down the US economy

This topic was a hot issue in the media especially during the years 2007 to 2008. All the headlines were covering the financial crisis in the US which was attributed to the breakdown of the subprime loans. How did housing loans become so powerful to throw the whole US economy into a severe financial crisis?

First let’s start off with what a subprime loan actually is. For example, if you would go to the bank and wish to borrow money to buy a house, would they just lend you the money instantly? The answer is no. Obviously, the bank will thoroughly check through your background, financial status and your assets to back you up in case you are unable to pay back their money. All the banks would close shop by now if they would just issue loans without checking if the borrower is even eligible for such a sum of money. Well, basically this is what happened in the USA.

A subprime loan is a type of loan whereby bankers issue housing loans to borrowers who are actually unable to afford to pay back that sum of money. During that time, bankers were confident as they could simply repossess the house if the borrower cannot repay the loan. Simply speaking, if the borrower stops paying, the bank gets their house and they can resell it for a higher price. Back then in 2006, the property market was booming and this is one of the main reasons banks were so keen to give out housing loans without following the proper procedures. Unlike the traditional loans that take time to get approved, these subprime loans were so easily obtained and this attracted many borrowers. The only price to pay was that interest rates would be much higher after the first few years of the loan.

Subprime loans began over a decade ago, and the problem only surfaced in 2007 when many people were unable to afford the loan repayments and interests. If they stop paying, the banks can take their houses and sell it off. Unfortunately, due to the massive amounts of loans given out and with such a high default rate, property prices were crashing down. Why? Since people knew they could not afford the repayment plus the value of their loan exceeded the value of their house, all of them just let go of their houses and let the banks have them. Nobody wanted the houses anymore, and when supply exceeds demand, this price is driven down. Banks could not sell the houses at prices enough to cover the cost of the loans they had given out. As a result, many financial institutions had to shut down.

Moving on, why did the house prices decline so much? Basically there was a housing boom in the 1990s, and lots of speculation that prices will keep increasing, thus driving prices higher and higher. A housing bubble was built and burst when the housing prices failed to appreciate as expected. Anyways, what goes up must come down. The housing prices could not be increasing forever. This property bubble plays out in the recent Dubai crisis.

There’s always something to learn from history. One important lesson from this crisis that had a major impact on US and the rest of the world is that any money flow without any solid backing will have to fall. In a nutshell, all the high property prices were caused by mere speculation, with no true intrinsic value. But everyone was banking on it and taking loans in hope that they could sell it off quickly at a higher price to repay the loan taken. Like dominoes, they have collapsed and turn into nothing.

Nevertheless, the US economy is starting to see recovery and is picking up once again. One thing for sure, is that the government policies would be keeping an eye to ensure financial institutions do not get involved in such high risk activities anymore.

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