Today million are still jobless with an unemployment rate at 9.7%, credit is tight, and businesses are slowly building back up. The sub-prime financial crisis of 2007 and 2008 financially destroyed the lives of many, but how could this have happened?
So what is a sub-prime mortgage anyways? According to investopedia.com, a sub-prime mortgage is, “a type of loan granted to individuals with poor credit histories (often below 600), who, as a result of their deficient credit rating, would not be able to qualify for conventional mortgages. Because sub-prime borrowers present a higher risk for lenders, sub-prime mortgages charge interest rates above the prime lending rate.”
Our credit rating is called our FICO score, which is simply a numerical value that through evaluation of our prior credit related purchases determines our credit risk or possibility of default. This process of generating scores was through the use of computer technology, which has enabled financial institution and other lenders, a more cost-effective process to determine who should be given a loan.
Stepping back for a moment, we should understand that a mortgage is a loan given to households or businesses for the purpose of purchasing a home, land, or other structures. That property is used as collateral for the loan if the borrower should default.
In addition, we should understand risk and the underlying ways that we need to expect to see to occur. As we know, anytime we give an individual the benefit of the doubt that their word will be upheld a degree of risk involved. What’s more is that all information is not always available equally to all parties involved this is called asymmetrical information. This lack of information on the behalf of the lender increases the risk taken.
We can see asymmetrical information in the form of adverse selection. Adverse selection occurs prior to the