Sunday, February 8, 2015

Recession and Subprime Lending

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For a healthy economy, a country needs to have smooth economic activities of production, distribution and consumption of goods and services at all levels. But what if all these activities drastically reduced (due to some reason) to a very low-state and continues to be in that state for a long time?
This kind of slowdown or a massive contraction in economic activities, is known as Recession. It may last for some quarters, which have a great adverse effect on the growth of an economy (making negative GDP growth, may be). Other adverse effects, like - 
  • Unemployment
  • Drop in Stock Market
  • Decline in Housing Market
  • Business losses
  • Social effects, like low living standards, low wages, etc.
The technical indicator of a recession may be two consecutive quarters of negative GDP growth. Recessions can occur for excessive subprime lending, as described below.

Subprime Loans
A bank generally follows a credit scoring system to determine borrowers eligibility for a loan. If a borrower doesn't have a good credit history, then the bank can deny him/her a loan. But if the bank decides to allow him/her a loan (even with that limited credit history), then the loan is known as subprime loan.
This type of loan carries more credit risk, and therefore carries higher interest rate. Think what will happen, if he/she eventually cannot pay back the loan (with extra interest rate on it!)

US Subprime Crisis of 2007-09
US banks started to lend subprime loans to the low credit borrowers, with houses, or properties as mortgage. They thought that if the borrowers become unable to pay back, then they could seize the properties and sell in high prices to recover the loans. 

But what happened is the prices of houses/properties declined drastically, leading to mortgage delinquencies and devaluation of housing-related securities. This led the banks to become bankrupt (e.g., Lehman Brothers), because they couldn't recover the amount of their huge subprime lending against mortgage securities.

Current Recession in Venezuela
Due to political instability and falling oil prices, Venezuelan economy (highly dependent on oil exports) shrank by 2.8 % in 2014, while inflation topped 64 %. It led Venezuela to fall in recession.

Hope this post will help you understand the concepts.
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