What Was The Subprime Mortgage Crisis

What was the subprime mortgage crisis? The subprime mortgage crisis was an intricate and devastating financial debacle in the late 2000s. However, the underlying reasons had been brewing beneath the surface for many years beforehand, snowballing from an unethical lending structure and lax regulatory bodies.

Originating from the US housing market, the consequences of this event are still felt today. It spurred stricter credit requirements and created a lasting rise in unemployment rates. We'll discuss the core contributors to the 2007-2008 subprime meltdown and what signs may indicate a repeat of the event.

What Caused the Subprime Mortgage Crisis?

During the 2008 mortgage crisis, often referred to as the subprime meltdown, various factors led to the need for oversight from financial and governmental bodies. In this context, financial instruments like home insurance coverage became crucial, offering protection against foreclosures and property value declines.

So what caused the subprime mortgage crisis? The subprime meltdown was caused by multiple factors and required oversight from financial and governmental bodies.

Lending Standards Deteriorating

At the center of the crisis was the lowering of lending standards. Motivated by profit, financial institutions repeatedly decreased lending requirements until they were nearly nonexistent. Borrowers with subprime credit were approved for mortgages far above their ability to pay.

Subprime mortgages were characterized by minimal credit standards, adjustable interest rates, and predatory initial terms designed to hide future risks. This resulted in an extremely high number of defaults, undermining the structure supporting mortgage investing.

Increase in Hazardous Mortgage Products

A famous moniker for subprime mortgages was "NINJA" loans. The term was used because the loans were designed for people with "no income, no job, no assets." AKA: No ability to pay.

Investment firms profited by creating dangerous and unethical mortgage packages. These products bundle high-risk loans together and reduce the overall risk. The problem is that the supporting loan's risk was so high that bundling them could only delay the meltdown.

Another problematic practice was adjustable mortgage rates (ARM). 

Home buying and selling is a complex dance, and borrowers, eager to secure a place to call their own, often find themselves in desperate situations, willing to sign anything within their financial reach. Lending institutions understood this and created ARMs with great initial interest rates, but they became unsustainable over time.

The biggest issue was that interest rates changed in response to MBS' successes. Interest rates did not change if the generated profits from an MBS were enough to appease investors. However, as more borrowers defaulted, profits fell, increasing interest rates to cover the losses.

Influence of Government Policies and Regulations

As soon as regulations surrounding the use of customer funds loosened, financial institutions took advantage. They started investing other people's money in various products, and many skirted the law by deliberately hiding their risks.

Banks started partnering with each other, interconnecting their businesses so that insolvency at one damaged all the others. Such a connection might sound like an increased risk, but its purpose was to make the banks "too big to fail."

This term was given to entities whose bankruptcy would damage the entire country's financial system and force the government into distributing aid.

In the subprime crisis, multiple banks considered too big to fail faced bankruptcy. The government initially vetoed a bill to "bail out" these institutions, which led to mass panic and the Great Recession. Eventually, as the banks predicted, Congress was forced to approve a $700 billion bailout.

Role of Investment Banks and Financial Institutions

Investment banks are heavily engaged in creating and trading MBS and CDS. Institutions believed these products were adequately hedged and made speculative investments on the assumption that the housing market would continue to thrive.

This overconfidence in the housing market significantly increased losses by massive investment firms when the bubble inevitably burst. They had overextended their resources and borrowed funds to increase returns. Rather than confining the consequences, these investments amplified damages across various industries.

Financial Instruments and Institutions

Amid the subprime mortgage crisis, financial instruments and institutions were central to the economic downturn. Home insurance coverage, designed to shield homeowners, gained prominence as a vital financial instrument during the crisis, offering protection against foreclosures and property value declines. The institutions managing these policies faced the challenge of navigating mortgage-related risks. This crisis underscored the interconnected nature of financial instruments like home insurance coverage and the institutions supporting them, emphasizing the need for robust risk management within the broader financial system.

Function of Mortgage-Backed Securities in Securitization

Securitization is the term for taking financial assets, like mortgages, and transforming them into tradable investments. They're designed to reduce the risk of investment products. 

Mortgage-back securities (MBS) were one of the prime securitization methods leading up to the meltdown.

By bundling subprime mortgages together, investment firms could hide the risk of individual loans. This works by using successful borrowers' principal and interest payments to mask the defaulted payments. The more loans bundled together, the more the risk is spread.

However, this has an obvious flaw. If there are too many defaulted loans, it becomes too much to cover with other sources. This is precisely what happened in the mortgage crisis.

MBS had another deceptive quality. The complexity of their structure made it difficult for investors to assess the actual risk of securities. They would have to evaluate individual borrowers' credit quality and history within a massive pool of loans. This degree of predictive analysis was not a common standard for firms then.

Credit Default Swaps (CDS)

Credit default swaps were a form of insurance created to hedge against the default risk of an MBS. These instruments didn't operate like traditional insurance but were akin to partnerships between financial institutions.

In a CDS, the buyer purchases an MBS and pays a premium to the seller, who agrees to compensate the buyer if a default occurs. The system appeared straightforward and quickly became the accepted standard when purchasing MBSs.

However, the oversaturation of CDS trading only heightened the risk to the US market. Default swaps were a significant factor tying banks' resources together and contributing to the "too big to fail" title. Because a single MBS could damage multiple banks, the government had to bail out the practices to avoid the worst possible scenario.

Global Impact

Starting in the US, the subprime market crisis triggered a severe worldwide recession. This time is also called the Great Recession, as its severity was only matched by the Great Depression in the 1930s.

Major financial institutions faced collapse, prompting governments to intervene with massive bailouts. The extremity of these bailouts rippled through societies as other sectors suffered from reduced funds. The crisis led to a global credit crunch and changed the dynamics of international trade.

The long-term economic scarring includes persistent unemployment and slowed economic growth in emerging markets. The crisis highlighted the relationships of the global economy and the necessity of international cooperation.

Conclusion

The subprime mortgage crisis was a turning point in financial history, exposing flaws in lending practices, investment products, and regulatory oversight. Its consequences shook the globe and triggered a two-year recession that continues to shape the financial landscape. Despite subsequent regulatory reforms, the scars of the crisis linger, influencing public trust in finance and housing.

FAQs

Is Another Subprime Mortgage Crisis Coming in 2024?

The Federal Reserve Bank has mentioned signs of a "Brewing US housing bubble," and people are worried about the possibility of another crash. However, later reports found that the recent increase in home prices isn't a conclusive sign of a bubble and may indicate dynamic shifts in global supply chains.

Were There Solutions That Could Have Mitigated The Subprime Mortgage Crisis?

There were many contributing factors to the meltdown, and addressing any of them could have significantly mitigated the aftermath. Practices like stricter lending standards, governmental regulatory interference, and increased transparency in investment products were critical takeaways from the catastrophe.

What Were The Key Outcomes of The Subprime Mortgage Crisis?

The aftermath involved a foreclosure crisis, a severe economic recession, and long-term consequences that reshaped financial regulations. The effects didn't stop in US markets; they damaged global trade, especially in Europe. The crisis prompted a reassessment of risk management practices and led to regulatory reforms to prevent a recurrence.

Impact of The Subprime Crisis on Public Trust in Finance And Housing.

The subprime crisis greatly damaged public trust in financial and ratings institutions. The idea of a "friendly bank" all but disappeared, and people hesitated more when buying homes. This shift in atmosphere may contribute to the new generation's rental lifestyle, alongside rising home prices.