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Prime or Subprime: The Good, the Bad and the Ugly

Prime or Subprime: The Good, the Bad and the Ugly

I am sure most of you, at least I hope so, have followed the national and international effects the meltdown in the Subprime mortgage market. Before we get started, please answer the following question:

1. What exactly is the Subprime Mortgage Market? Please provide details.

The Subprime Mortgage meltdown has had global reverberations. It has had a negative effect on the global financial markets. Large Banks, national and international, have purchased hundreds of billions of dollars in subprime mortgage loans. The U.S. and international stock markets have fallen several hundred points in the last few months.

If you have substantial stock holdings, you may be getting nervous or at least concern. The world's economies are slowing down. Please answer the following questions:

2. Why did national and international banks purchase hundreds of billions of subprime mortgages? What made them so attractive?

3. What has been the effect of the subprime mortgages on the net income of the world's banks? Why?

4. Assuming you were able to answer the first question correctly, what do you think of the old adage "you do not lend money to someone who cannot pay you back (as it relates to the subprime market meltdown)?" Please think about it.

5. Over the last few years, owning a house has been an excellent investment. Houses have been a wealth-builder. Some of us have used our house as a literal
"piggy bank."

a. What made owning a house such a great investment?
b. What role did the principles of supply and demand play?
c. What role did low interest rates play in fueling the housing market?

Your answers will require some external research.

Solution Preview

1. What exactly is the Subprime Mortgage Market? Please provide details.
Subprime Mortgage is a loan at a higher rate than the prime rate. These loans do not meet Fannie Mae or Freddie Mac guidelines. They are generally known as second chance lending or "B" paper as opposed to "A" paper. It is risky to the lender because the borrower has poor credit and it is risky to the borrower due to their high interest rates and could put them in a financially adverse situation. Subprime mortgages extend credit to people who would otherwise not have access to a loan or credit.
2. Why did national and international banks purchase hundreds of billions of subprime mortgages? What made them so attractive?
Many places throughout the world have uncertain economies and much political conflict. Wealthy investors want to move their assets out of these regions and into the safer and stable economies. Investors world-wide have placed their funds with American homes simply due to the fact that the country will not take your property without compensation and many Americans will pay their home loan before they pay any other bill. There is less of a risk, but still many have subprime rates which makes gives the investor a higher yield.
3. What has been the effect of the subprime mortgages on the net income of the world's banks? Why?
Because most of the world's banks bought subprime mortgages in 2004 and 2005 (Miller, 2007), most borrowers have had trouble making their payments after the interest rates jump on their variable loans. Some payments increased over 30% and since they are unable to refinance due to the strict limitations on subprime loans ...

Solution Summary

This solution answers specific questions on prime and subprime markets including the definition of both.

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