Sub-Prime Mortgage: The Snowball Effect
Michael J. Brown #530570
EC 301: Intermediate Macroeconomics
October 7, 2008
Sub-prime mortgages were a lucrative new market idea, pushed by the government, executed by the lending institutions, in order to provide everyone the American Dream. During the expanding economy, this dream became a reality—untested and unchecked—as low interest rates fueled the desire of investors to make dreams come true! Ultimately, the vicissitudes of the economy turned downward and the snowball effect began while financial sectors and investors scrambled to catch the falling knife. While history is being written this very day and hindsight is 20/20, we can reflect on the ideologies and policies that brought forth the worst economic downturn since the Great Depression.
At the birth of the sub-prime mortgage market, investors and lending institutions had found a way for more families to live the American Dream while they were able to profit. The economy was booming, the unemployment rate was low, and the demand for housing was high due to low interest rates. The idea was that lenders were willing to accept more risk by financing homes with less equity to those that were not creditworthy. The incentive to the lender was a higher interest rate to the consumer, while expecting a higher foreclosure rate. Due to the high demand for housing, assets were also appreciating decreasing the implied risk. Add in the origination fees, suddenly the entire proposition became very profitable. In theory, the market assumed an annual foreclosure rate of 8% with the average loss due to foreclosure being 30%. Over a $1.2 trillio ...