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  • 1.CURRENT ISSUES IN INTERNATIONAL & OFFSHORE BANKING GB 30403What Causes Subprime Mortgage and Its Effect Toward Caribbean?1.0 Introduction The United States (US) economy has experienced its worst financial crisis since the Great Depression. The financial crisis started in the home mortgage market, especially the so called subprime mortgages, and is now spreading beyond subprime to prime mortgages, commercial real estate, corporate junk bonds, and other forms of debt. Total losses of US banks could reach as high as half of the total bank capital, which would lead to a sharp reduction in bank lending, which in turn could cause a severe recession in the US economy. The financial crisis distressing the US economy would have already embarked the Caribbean into an economic blackout. It is uncertain that this will happen but the external undulations of the financial crisis in the US will cause an economic depression in the Caribbean(Smith, 2008).The objective of this paper is to study and determine several key factors, which are:1. To understand what is subprime mortgage.2. To understand how the subprime mortgage occurred in United States3. To understand and identify what is the causes of subprime mortgage4. To understand and identify what is the effect of subprime mortgage towardCaribbean5. To determine how to solution the subprime mortgage2.0 Brief History in Subprime Mortgage Crisis The subprime mortgage crisis of 2007 originated from the US subprime mortgage market developed into a global financial crisis in 2008. Basically, banks lent too much money to people who were unable to repay their debt. However due to the close collaboration of world banks and Hedge Funds who make subprime mortgage backed securities, the crisis leads to worldwide liquidity crisis.1|Page

2. CURRENT ISSUES IN INTERNATIONAL & OFFSHORE BANKING GB 30403 This starts whenmortgage lenders sanction loans to the borrowers who are not mortgagequalify for mortgages at market rates. These mortgages have easy initial paymentsbut it includes adjustable rates of interest if the market changed. During the timewhen housing prices were increasing, several borrowers took on difficult mortgages,sthinking that as the value of their homes increased and they will be capable ofrefinancethe properties (Smith, 2008) Unfortunately, the borrowers start to default Smith, 2008).on the home loans payment because it was expensive when the interest rateincreased rapidly. Furthermore the borrower unable to refinance the properties as the housingbubble came to an end. The property value also diminished. Consequently, thelenders were unable to regain the money that they had invested previously on themoneyproperties.Graph 1: Housing Activity Drops OffSources: National Association of Realtors; Census Bureau; authors calculations2|Page 3. CURRENT ISSUES IN INTERNATIONAL & OFFSHORE BANKING GB 30403Graph 1 describes that after booming the first half of this decade, US housing activity has economized suddenly. DiMartino & Duca (2007) stated that the single- family buildings authorities to have plunged 52 percent and existing-home sales have dropped 30 percent since their September 2005 summits. An increase in mortgage interest rates that started in the summer of 2005contributed to the housing markets early weakness. By late 2006, though, certain signs pointed to improved stability. However, they proved short-lived as loan-quality problems generated a tightening of credit standards on mortgages, mainly for newer and riskier products. The lenders reduce lending loan and the housing activity began to falteronce more in spring 2007, accompanied by additional increases in delinquencies and foreclosures. By late-summer financial-marketdisorder stimulated further strengthening of mortgage credit standards.3.0 What is subprime mortgage? Subprime mortgage is a mortgage initiate of an asset to a creditor as security for a loan to purchase the property or assets.The subprime mortgage crisis is a constant financial crisis caused thru a dramatic escalation in mortgage negligence and foreclosures in the United States, with major adverse effects on the banks and financial markets all over the world. The crisis started in the year 2007 and has revealed pervasive weaknesses in financial industry regulation and the global financial system. Subprime mortgage is a financial innovation that normally occurs in the situation which is relevant to the roots of subprime mortgage lending and the existence of previously underserved borrowers and investors, the substance of advances in technology and encouraging regulatory environment (Jaffee, 2008).Furthermore, subprime mortgages are unsafe to the creditors and borrowers due to the combination of high interest rates, bad credit history, and not clear about personal financial situations often related with subprime applicants (DellAriccia, Igan and Laeven, 2009). The subprime mortgage market offers an almost ideal ground for testing such theories because it is a less advanced credit market with significant 3|Page 4. CURRENT ISSUES IN INTERNATIONAL & OFFSHORE BANKING GB 30403informational irregularities. The USA financial crisis has a link between creditgrowths and lending standards in the subprime mortgage market and also identifyingmodifications in the structure of local credit markets as issues increasing this declinein lending standards (DellAriccia, Igan and Laeven, 2009). Generally subprime mortgages would have an excessive risk of assessmentrating. However once the mortgage bundles got approved by other lenders, therating agencies offered these risky subprime mortgages a low risk rating.Consequently, the financial system refused the extent of risk in their balance sheets.These mortgages had an introductory duration of one to two years of very lowinterest rates. At the end of this period, interest rates elevated. In 2007, the US wasrequired to raise the interest rates due to inflation. This approach showed that themortgage payment was very expensive. On the other hand, many homeowners who had removed mortgages 2 yearsearlier right now encountered ballooning mortgage payments as their introductoryperiod ended (Pettinger, 2011). Homeowners also encountered lower disposableincome due to developing health care costs, increasing petrol and food prices. Thistriggered a rise in mortgage defaults; several new homeowners were unable toafford mortgage payments. A study in 2007 shows the monthly payments for 60%of the total adjustable-rate mortgages created since 2004 will boost up by 25% ofmore (Sugunendran, 2008). These defaults indicated the end of US housing boom.US house prices began to drop which started more mortgage problems. Forexample, people with 100% mortgages now encountered unfavourable equity. Itsignified that the loans were no longer secured (Pettinger, 2011). Even if the peopledid default, the bank couldnt ensure to collect the initial loan. A variety defaultsprompted many medium sized US mortgage companies to bankruptcies.4|Page 5. CURRENT ISSUES IN INTERNATIONAL & OFFSHORE BANKING GB 30403Figure 1: New Model of Mortgage Lending Source: BBC News According to the Figure 1, The Traditional model Lending where banks grantmortgage to the home buyer and the home buyer pays back to the bank but in thesubprime model lending bank sell mortgage bond to the mortgage bond market.From this the bank obtains credit to grant mortgage to the home buyer. Than this Thhome buyers pays back to the bank and the banks will pay back to the bondholders.If one of them default any of the payment everyone will start defaulting the paymentbecause it is a domino effect.5|Page 6. CURRENT ISSUES IN INTERNATIONAL & OFFSHORE BANKING GB 304034.0 Subprime mortgage in United States The subprime mortgage collapse which spread throughout the US economy and into international markets. US mortgage lenders sold many inappropriate mortgages to customers with low income and bad credit history record. It was estimated with a booming housing market, the mortgages will remain economical. Nevertheless, probably there were careless controls in the sale of mortgage products. The mortgage brokers was paid for selling a mortgage because there was a benefit to sell mortgages no matter if they were overpriced and might have high possibility of default (Pettinger, 2011). In order to sell more profitable subprime mortgages where mortgage companies included the debt into consolidation packages and sold the debt to other finance companies. In other terms, mortgage companies borrowed in order to lend mortgages. The lending was not financed through saving accounts, for example. These mortgage debts were purchased by financial intermediaries. This was to spread the risk but conversely it only just spread the dilemma.Generally subprime mortgages would have an excessive risk of assessment rating. However once the mortgage bundles got approved by other lenders, the rating agencies offered these risky subprime mortgages a low risk rating. Consequently, the financial system refused the extent of risk in their balance sheets. These mortgages had an introductory duration of one to two years of very low interest rates. At the end of this period, interest rates elevated. In 2007, the US was required to raise the interest rates due to inflation. This approach showed that the mortgage payment was very expensive.On the other hand, many homeowners who had removed mortgages 2 years earlier right now encountered ballooning mortgage payments as their introductory period ended (Pettinger, 2011). Homeowners also encountered lower disposable income due to developing health care costs, increasing petrol and food prices. This triggered a rise in mortgage defaults; several new homeowners were unable to afford mortgage payments. A study in 2007 shows the monthly payments for 60% of the total adjustable-rate mortgages created since 2004 will boost up by 25% of more (Sugunendran