- Education and Science»
The Subprime Mortgage Debacle II: Predatory lending-aka, Financial Arbitrage!
According to the popular financial website Investopedia.com "an arbitrage is a "free lunch"—a transaction or portfolio that makes a profit without risk. Just like FHA and VA loans, subprime loans were mostly used for first time home buyers who desired to purchase what was called a “starter home.” But in the case of subprime mortgages this concept got taken a bit further: subprime lending was lending associated with even more inherent risk; hence, just like any other “high risk” investment, there has to exist some form of “high rewards.” Also, in order to achieve these “high rewards” subprime loans became synonymous with extremely high interest rates. This particular feature of subprime loans was due to the greater risk associated with the lower income borrower’s poor credit history thus a greater chance of defaulting.
Predatory Lending: A Virtual Game of Blackjacks
All the same, both parties involved in the subprime deal seemed eager to get papers signed: on one side of the table, borrowers were more than elated to use subprime loans to get inside a “home of their own;” and on the other side of the negotiating table, lenders were more than willing to sell off (to the highly motivated borrower) these “astronomically high interest rate debt instruments”—aka, “astronomically high ‘high profits’ to certain banks.” A bank, just as any other private institution has to be motivated by profit, however, when you direct “astronomically high interest rate debt instruments” at a certain demographic of society then this crosses over to the very idea of this “need for greed” ideology that exist in today’s kamikaze economical world.
Predatory Lending: Commericial Banks Being Greedy
Fact is the practice of predatory lending was commercial banks being greedy—to be exact, banks began using subprime loans in a very deceptive manner simply as a way to cheat the system. Predatory lending is based on the premise that a highly motivated and uninformed borrower should find it hard to decipher the labyrinth process (expensive prepayment penalties, hidden fees, misc. charges, etc) of traditional mortgage lending. Predatory lending was a pure game of deception and as about as kamikaze economics as one can think of. To say the least, in the quest for this high return/high profit nirvana, lenders extended credit to borrowers previously unable to qualify for loans.
Subprime Mortgages: A Typhoon of Financial Fraud
Subprime mortgages rose from only 8 percent of originations in 2003 to an astonishing 20 percent in 2005. By the late 2007 we had a serious subprime financial crisis on our hands. Frederic S. Mishkin author of the economic book titled, “The Economics of Money, Banking and Financial Markets” goes on say the following:
The subprime financial crisis had a major negative impact on the economy leading to a downward revision of the growth prospects for U.S. companies, thus lowering the dividend growth rate (g) in the Gordon model. The resulting increase in the denominator would lead to a decline in stock prices. However, when the crisis entered a particularly virulent stage in October of 2008, credit spreads shot through the roof, the economy tanked, and as the Gordon model predicts, the stock market crashed, falling by over 40% from its peak value a year earlier.
In conclusion, the prevailing economic lesson of this subprime mortgage debacle may be one of throwing overt financial caution to the wind. The subprime mortgage crisis—aka, subprime financial crisis, illustrates just how volatile financial markets can be. This macroeconomic financial volatility trickled down to the personal finances of your everyday consumers creating much difficulty in getting loans, falling home values, declining retirement account values, and more importantly, declining job security.