Subprime Mortgage Crisis
What is Subprime Mortgage Crisis?
The subprime mortgage crisis was the wave of American home loan defaults that, amplified by securitization and bank leverage, set off a global financial panic.
Through the mid-2000s American lenders wrote mortgages for borrowers with weak credit, often at low starter rates that reset upward after a couple of years. Those loans were bundled into securities and sold on, so the firm that approved a loan no longer bore the loss if it went bad, a textbook moral hazard problem. Banks and other financial firms bought the securities with borrowed money, holding only a thin slice of their own capital against them. When house prices stopped rising, defaults climbed, the securities fell in value, and institutions borrowing twenty or thirty dollars for every dollar of capital found that capital wiped out. Lending froze, investment and consumption fell, aggregate demand shifted left, and the result was the deepest recession since the Great Depression.
Subprime Mortgage Crisis: a worked example
The arithmetic of borrowed money explains why a housing loss became a banking collapse. Take a bank holding $100 of mortgage securities funded with $3 of its own equity and $97 borrowed, so assets ÷ equity is about 33. If the securities fall just 3 percent, the loss is $3 and the equity is gone, leaving the bank insolvent even though 97 percent of the value survives. Every lender to that bank now has a reason to pull its funding first, which forces asset sales and pushes prices down further. The same 3 percent fall would barely dent an investor who had paid cash.
The mistake students make with subprime mortgage crisis
The usual mistake is to say subprime borrowers caused the crisis. Subprime defaults were the trigger, but they were small next to the financial system as a whole; what turned them into a panic was borrowed money, opaque securities, and the fact that the losses landed on institutions everyone else depended on. A second error is calling it a shortage of liquidity only. Firms holding assets worth less than their debts were insolvent, and lending them cash does not fix that.
Subprime Mortgage Crisis questions
What is a subprime mortgage?
A subprime mortgage is a home loan made to a borrower whose credit history, income documentation or existing debts would not qualify them for a standard prime loan. Lenders charged higher rates to offset the higher default risk, often starting with a low teaser rate that jumped after a couple of years. When those payments reset and house prices stopped rising, many borrowers could neither pay nor refinance.
How did mortgage defaults turn into a global financial crisis?
Mortgage defaults spread worldwide because the loans had been packaged into securities that banks in many countries bought with borrowed money. Losses on those securities destroyed bank capital, and banks stopped lending to each other because nobody knew who was holding the bad paper. Credit dried up for ordinary firms and households, which pulled aggregate demand down across many economies.
Why did credit ratings fail during the subprime crisis?
Rating agencies gave top grades to mortgage securities because their models assumed house prices would not fall across the entire country at once, so pooling loans from different regions looked like genuine diversification. When prices fell everywhere together, the loans defaulted together and the pooling gave no protection. The agencies were also paid by the issuers whose products they rated, which weakened the incentive to be strict.
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