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Our 2007-2008 financial crisis is blamed on cheap mortgage credit, including lax underwriting process and government policies. In 2003, the government passed the American Dream Development Act, which provided financing to low-income families. Trying to help lower middle class families, the policy led to mortgage subprime mortgages. Financing to families with low credit rating at high interest rates. Since a large part of the population is middle to lower class, an exhaustible demand for new homes was created.
As a result, creating a bubble in home price.
Some of these mortgages include Interest only (monthly payment pays nothing to the principal, thus never decreasing the principal amount financed), and Adjustable Rate Mortgage, which consists of lowering or increasing rates every year depending on market interest rate. This type of mortgage can be beneficial in times like this; but back in 2006, when interest rates were so high, many mortgages monthly payments increase more than 10% in just one month.
As Interest rates increased, subprime mortgages started to default exponentially since new homebuyers were unable to meet the monthly payments.
This led to the collapse of home prices. This period of time is called the Great recession. The increase in subprime defaults reduces aggregate income and increases aggregate home prices, which in turn increases the level of prime defaults in the economy. This is called the subprime contagion. How did the government react?
The government used fiscal policy to stabilize interest rates, reduce unemployment and increase GDP, they issued a program of Easy Credit, letting subprime borrow at a prime borrower spread.
Also, they gave a Tax Rebate in 2008 of $8,000 for First time homebuyers, and for those in default they issued the Distress Relief program of HAMP (Home Affordable Modification Program). On the other hand, the Fed used monetary policy to reduce the economic crises and spur investments and consumption. They reduce the rate at discount window, increase money supply to reduce rates and they purchase mortgage-backed securities.
Using Monetary Policy in a recession is more effective because it acts faster than fiscal policy. Fiscal policy has go through a various committees and has to be voted on to be made into law. As a conclusion, there is a contagion effect od subprime default due to the negative impact of subprime defaults on aggregate income, and monetary policy is the most effective when dealing with a recession. Monetary policy increases home aggregate prices in contrast to alternative government fiscal policies designed to loosen mortgage credit.
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