Updated: Mar 26, 2021
The previous sequels of the series: “10 Years of Financial Crisis 2008” must have left you wondering what are subprime mortgages? Why were they the major cause behind the “The Great Recession”? Well, I had the same query too!
To begin with, let us explore about what are mortgage loans? Mortgage is an agreement whereby the borrower can use the house which he is would like to buy itself as a collateral. Wow! Now the lender has the right to seize the property when the borrowers fails to pay back. So, what will happen if the borrower cannot pay back and the house rates are decreasing? The security of the lender will decrease with the fall in rates. Keeping this in mind, what are subprime loans?
A subprime mortgage is a type of loan granted to people with poor credit scores, that people with a higher possibility of defaulting. Hence, there is high risk involved in such type of mortgages. The hedge funds, banks and the investment banking companies are the culprits behind the “Subprime mortgage Crisis” which unfolded into the deadly “Financial Crisis of 2008”.
The Hedge Funds. They created demand for mortgage-backed securities by pairing them with cred default swaps which acted like guarantees. The problem arose when the Fed started to increase the interest rates and those with adjustable-rate mortgage could not pay back.
An increase in the interest rates led to a decrease in the demand for house which led to a steady decline in the house rates. Recollecting from above, when the price of the houses went below the borrowed amount, it decreased the security of the banks. The AIG almost went bankrupt trying to cover the insurance.
Now, the mortgage-backed securities allowed the banks, the lenders to bundle loans into a package and resell them. The banks and hedge funds saw that they were making so much money by selling these mortgage-backed securities. This added so much liquidity in the market. Again, the risk was small when the housing markets continued to rise. We can now imagine the disaster when the housing markets go down the these are subprime mortgages!
So, why will the banks lend subprime mortgages and interest-only loans? In an anticipation that the housing markets will only rise and they can recover any default by selling the houses.
This risk, which must be noted, wasn’t restricted to mortgages. Collateralised Debt Obligations (CDO) too was a partner-in crime. Under CDOs all kinds of debt were packaged to be resold.
In 2006 when the Fed increased the interest rates, all the “possible” disasters unfolded into “real” and by now we can imagine the amount of default which was created. The housing prices fell, and the borrowers could not resell their houses. Defaulting was the natural way out for the borrowers. The banks had already repackaged these loans. Connecting the dots, how did these affect the banking industry.
The banks were large buyers of the CDOs. The credit rating agencies too had their role to play. The banks being unable to sell these sick CDOs, the Fed had to step in. As the home prices fell, the banks avoided lending to each other because of high chances of getting a mortgage collateral. This is a toxic situation in the financial system where banks lose trust in each other. “The Financial Crisis 2008” unfolded and rapidly spread across the world and turned into a global crisis.
To conclude with, this subprime mortgage crisis could have been prevented with the regulation of the banks from lending to borrowers with poor credit score. Further the hedge funds could have been monitored from taking high risk and installing a checking mechanism on the credit rating agencies. These being the straight forward solutions to the problems, various other economic reports need to be seriously considered. Underestimation of the seriousness of present facts should be avoided.