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 1990s 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
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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
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 couldnt 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
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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 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.