Part 2
These borrowers very often do not understand the types of loans or the contracts they sign, which denies the ability to asses true risk. The problem includes appraisers using inflated figures to value houses.
Lack of government regulation has also been blamed as being the cause of the problem.
Subprime lenders naturally foreclose on properties at a much higher rate than conventional lenders. Statistics show that approximately 3.3% of subprime loans end up in foreclosure compared to 1.1% for conventional loans.
The subprime meltdown is said to have begun in 2006, with escalating number of subprime house foreclosures.
The relationship between subprime meltdown and house prices is as follows:
As house prices drop, the equity value of home mortgages goes down, this creates an increase in mortgage defaults which will cause a further drop in house prices.
This positive feedback relationship will simply create a snowball effect until the economy has reasons to believe that there are reasons for the reverse to happen.
The subprime problem could also seep into other sectors in the economy. The housing slump is estimated to be able to strip 1-2 points off the GDP figure, furthermore, the downturn in the housing market will drag down the construction sector which will further affect other industries like i.e. plumbing, furniture and home improvements.
The FED responded to the crisis by prescribing methods to regulate the mortgage industry and enhancing laws where high levels of due diligence is needed in assessing borrowers ability to pay as well as make sure there is a much clearer understanding on the terms of the loans.
These guidelines were put forth with the hope to prevent or at least reduce fraud and abusive lending in the future.
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