Financial Crisis and Predatory Lending

Financial Crisis and Predatory Lending

The Financial Crisis an Predatory Lending

What really caused the financial market to crash? Was it jobs being shipped overseas, or maybe a huge increase in consumer debt? There were actually a number of causes, but subprime lending and predatory lending practices were some of the largest. This paper examines how subprime and predatory lending became so popular and overlooked right before the housing bubble burst. It then looks to examine how this eventually generated the extreme financial situation that this country has still yet to get out of.

The recent recession was one of the worst that this generation has ever seen. Thousands of Americans lost their homes and savings, and many more had to face serious financial hardships which took away a portion of the quality of their lives. The financial crash that started in 2007 and 2008 is still continuing to wreak havoc throughout the United States and abroad across the entire globe. This has left many wondering what happened and where everything went so wrong. It is clear that there were a number of factors involved in the eventual decline and crash of the American economy. All of these factors work together a consortium to cause the financial disaster as it played out. However, one of the biggest causes was the burst of the housing bubble that led to massive debt and thousands of foreclosures of homes all over the country. Subprime lending and predatory lending all played a large role in how so many Americans took out mortgages that they simply could not afford when the economy started to take a downward turn. As such, the housing market, subprime loans, and predatory lending, all played a huge role in the development of the financial recession that this country is still trying to get out of.

Onslaught of the Financial Crisis: Explosion of Subprime Loans

The beginning years of the new millennium saw a lot of affluence in American society. Many who would've otherwise been renting in any other economic situation began looking to buy homes while interest rates were at record lows. So many Americans when out to go take out mortgages. However, not all of these mortgages were made under the best circumstances. There were many who simply could not afford the mortgages they were so seeking. Yet, banks could not help but take advantage of the rise in demand for mortgages. According to the research, "the oversupply of money to lend drove lenders to explore new markets, and offer relatively marginal borrowers more credit than they had ever had before" (Baker, 2008). This seems as though it might be dangerous for banks, considering that many of these subprime loans were vulnerable to foreclosure. However, these banks were actually exploiting these subprime loans as a way to make additional capital by selling off securities. Essentially, "banks were anxious to issue loans that could not be paid off because they knew that they would be able to quickly sell them in the secondary market" (Baker, 2008). Whole new industry thrived off increasing number of subprime loans throughout the American economy. According to the research,

"the percentage of subprime mortgages as a percentage of all mortgages sold skyrocketed after 2003, rising from a historical average of around 6% of mortgages to over 18% in 2004, and 20% in 2005 and 2006" (Van Steenwyk, 2012). This was essentially to many risky subprime loans for the American housing market keep afloat for too much longer.

Eventually, these subprime loans showed how dangerous they were in a financial environment. With so many people rushing into mortgages that they could not afford later on, the housing market in the United States turned into a massive bubble waiting to burst. Here, the research suggests that "the irrational exuberance of a housing bubble created the climate in which homebuyers became eager to take on mortgages that they could not possibly afford and banks and investors were willing to make loans that couldn't be paid back" (Baker, 2008). It is surprising to think that banks could not see this coming from the beginning. Yet, their greed for profit on the secondary securities market continued to feed a dangerous environment. What were at stake were the dreams of thousands of Americans, who had just gotten a hold of their first home under risky mortgage circumstances. Unfortunately, these "relaxed standards encouraged speculation, which led to a rapid rise in mortgage defaults when home prices stopped rising" (Holt, 2009). No one knew how bad this crash would be. Later towards 2007, many in the financial industry began to try and stop the process of subprime lending. Yet, "the damage was done: Tens of thousands of borrowers who would normally have been renting were now property owners, thanks to subprime loans -- whether terms were predatory or not" (Van Steenwyk, 2012).

Predatory Lending

This leads into another discussion regarding the practice of predatory lending and its role within the decline of the American economy during the great recession. It is clear that "predatory lending practices in the subprime mortgage space contributed to the mortgage crisis" (Van Steenwyk, 2012). The practice just went unchecked for far too long. Predatory lending is essentially the practice of the financial institution taking advantage of a vulnerable client. When interest rates got so low, many predatory lenders when looking for subprime mortgage clients, knowing that they were not able to fulfill their mortgage obligations in the near future. This is not a deterrent, but rather an incentive based on the financial gains of having such individuals fall into default. Here, the research explains that "the existence of a fundamental asymmetry of information between predatory lenders and borrowers: Lenders simply have access to much more information about marginal borrowers, in the aggregate, than the borrowers have about their own prospects" (Van Steenwyk, 2012). Often times, the clients were misled or even flat-out lied to in order to encourage the sale of mortgage deals that were clearly not in the interest of the client financial stability. These lenders knew they could make a killing off selling the debt in the securities market. As such, "the companies originating these loans -- often on questionable or fraudulent underwriting standards, were able to sell them upstream to Fannie Mae and Freddie Mac, or to Wall Street firms looking to invest in packages of mortgages for the purpose of generating income for investors" (Van Steenwyk, 2012). This then secured the participation of some of the very financial institutions that are supposed to spearhead the nation's economic stability. With major banks stepping into the predatory lending situation, it was clear that things had gone too far. The crash was then partly responsible because of this high risk rate for predatory lending and the participation of major banks. Thus. "when recession came, and borrowers began to default, these securities began to unravel" (Van Steenwyk, 2012).

Housing Crisis

The damage was inevitable. All of the defaulted loans came back to haunt the financial institutions that were so lenient with subprime and predatory lending to begin with. What resulted was the complete collapse of the American financial institution to be able to deal with so much debt. As such, "the primary cause of the current recession was the credit crisis arising from the bursting of the housing bubble" (Holt, 2009). The housing bubble caused so much damage when it burst. It started first in the housing market, but then quickly spread to other financial avenues, including automotive production and manufacturing which suffered dramatically during the course of the recession. Unfortunately, no one seemed to notice how dire the situation with getting before it happened. It is true that "bubbles always burst and the process is often quite painful" (Baker, 2008). Falling interest rates enticed potential home buyers, often resulting in people overspending. Yet, financial watchdogs did not step in to stop the situation before it got out of control. Now, the housing crisis is still struggling to just barely stay afloat. According to the research, "home prices have declined markedly since their 2007 peaks -- and their precipitous decline sparked a liquidity crisis that continues to resonate throughout the global financial markets today" (Van Steenwyk, 2012). Yet the damage did not stay within the housing market at all. Today, unemployment rates are continuing to rise, with consumer debt at an all-time high, leading to extreme decline of the quality of life for the average everyday American. It is unfortunate to see that "banks have been short of ready buyers of foreclosed properties. As a result, inventories of unsold homes rose, demand for new construction plummeted, and thousands of workers lost their jobs -- leading to a new round of bankruptcies and foreclosures in a vicious economic cycle" (Van Steenwyk, 2012). The housing market may not be the only cause, but it is definitely one of the most infamous.