Subprime mortgage crisis

Definition

The subprime mortgage crisis refers to a financial crisis that occurred in the late 2000s, characterized by a sharp increase in mortgage delinquencies and foreclosures among borrowers with poor credit histories. This crisis led to significant disruptions in the global financial system, as it exposed the vulnerabilities of financial institutions heavily invested in mortgage-backed securities and resulted in a broader economic downturn.

5 Must Know Facts For Your Next Test

1. The subprime mortgage crisis was largely driven by lax lending standards, allowing individuals with low credit scores to obtain mortgages they could not afford.
2. Major financial institutions suffered massive losses due to their exposure to mortgage-backed securities that became worthless when homeowners began defaulting on their loans.
3. The crisis triggered a severe liquidity shortage in the banking system, leading to the collapse or bailout of several major banks and financial institutions.
4. Government intervention included programs like TARP (Troubled Asset Relief Program) aimed at stabilizing the banking sector and restoring confidence in the financial markets.
5. The aftermath of the crisis led to widespread economic recession, resulting in high unemployment rates and a significant decline in housing prices across the United States.

Review Questions

• How did the lending practices leading up to the subprime mortgage crisis differ from traditional lending standards?
  • Before the subprime mortgage crisis, lending practices became increasingly relaxed, allowing lenders to approve loans for borrowers with poor credit histories who would typically be denied. This included offering adjustable-rate mortgages with low initial rates that later increased, making it hard for borrowers to keep up with payments. Traditional lending standards usually required proof of income and higher credit scores, minimizing risk for lenders.
• Evaluate the impact of mortgage-backed securities on the financial institutions during the subprime mortgage crisis.
  • Mortgage-backed securities played a crucial role in amplifying the effects of the subprime mortgage crisis on financial institutions. Many banks heavily invested in these securities, assuming they were safe investments based on high ratings given by credit agencies. When defaults soared, these securities plummeted in value, causing significant losses and leading to the insolvency or bailout of major banks, which resulted in a cascading effect throughout the global financial system.
• Assess the long-term effects of the subprime mortgage crisis on both housing policy and regulatory measures within the financial industry.
  • The subprime mortgage crisis had profound long-term effects on housing policy and financial regulation. In response to the crisis, lawmakers enacted reforms such as the Dodd-Frank Wall Street Reform and Consumer Protection Act aimed at increasing transparency and accountability in the financial sector. Additionally, stricter lending standards were implemented to protect consumers and reduce systemic risk. These changes have shaped how mortgages are issued and regulated today, aiming to prevent a similar crisis from occurring in the future.

Related terms

Mortgage-backed securities: Financial instruments created by pooling various mortgage loans and selling shares of that pool to investors, which are then paid out from the monthly mortgage payments of homeowners.

Foreclosure: The legal process by which a lender takes possession of a property due to the borrower's failure to make mortgage payments.

Credit default swap: A financial derivative that allows an investor to 'swap' or transfer the credit risk of fixed income products, typically used as insurance against default on debt.