Question

Real Estate Finance essay question

Why did observers at first believe that the damage from the impending subprime mortgage crisis would be too small to cause a recession?

Answer 1

Subprime lending is the loan's, given by the banks to the people based on there creditworthiness, banks initially thought that they will earn high profits by giving loans at higher rate of interest to the people, in case if they fail to deposit the loaned amount back, the bank will profit by selling the land/home, they assumed that real state prices will rise with respect to time. Sooner the borrowers started to default on there EMI's, as well the availability of houses increased at such a level that nobody seemed to be interested, thus this asset is called toxic asset or the bubble burst has occured in the economy.

Initially, it is beleived that this subprime crisis would be too small to cause a recession because the market was on the peak, real state prices are high, investors worldwide are investing in USA, mortgage backed securities to stronghold securitization process, governments supportive policies etc are some of the factors that led to this mirage like situation.

As the borrowers defaulted, the creditors lost there confidence in the american banking system, soon the stocks crashed, people started taking there money back from the banks, the liquidity disbalanced, also it lead to the cascading effect, other european economies also affected as investors from this countries also occured big losses, in order to sustain this shock, there is high unemployement, cost cutting etc which further elevated the problems.