Containing Financial Contagion at the Source

Abstract

The world financial market is currently in turmoil because of the recent housing and credit crisis. From January to November 2007, more than 1 million homes in the United States entered foreclosure. Not only are homeowners losing their homes, but paying renters are being evicted as lenders reclaim properties. Depending on the state, 48–69% of foreclosed loans come from the subprime market. Subprime refers not to interest rates but to borrower quality, determined by low credit scores, little credit history, or unstable income with limited assets. Because of the increased risk associated with loaning to them, those borrowers cannot get favorable rates and often take out loans with short-term introductory rates. These loans generally get packaged by Wall Street into residential-backed securities and structured into slices or tranches that can be priced and rated from AAA to BBB– on the basis of the credit risk inherent in each tranche. When these mortgages adjust to market rates, the borrower no longer qualifies for the existing loan and can no longer pay it back. Because techniques such as gifted down payments and no requirements to prove income were the only way to move these borrowers into mortgages, many were lured into a false sense of prosperity for which they were neither prepared nor equipped and for which they are now suffering through foreclosure.