How the Subprime Mortgage Crisis Began

The subprime mortgage crisis that shook the financial industry in the US in 2008 was triggered by the burst of the housing bubble. It resulted in a large number of foreclosures and delinquencies, and caused reverberations in other sectors including manufacturing, financial, automotive, hotel, retail, and others.

In this article we will look at how the mortgage crises had started, and what were its consequences on the economy in the US.

How the Subprime Mortgage Crisis Began?

A number of factors can be linked to the subprime mortgage crises, with experts assigning blame to regulators, credit agencies, financial institutions, and consumers, among others. However, most financial pundits agree that the main cause of the crises was an increase in subprime lending.

Subprime loans are characterized by high interest rates and poor quality collateral. These loans are targeted to individuals with a low credit score, and entail less favorable terms to compensate the lender for taking on high credit risk.

Between 2004 and 2006, subprime mortgages had increased from the historical 8% to about 20%. In some parts of the US, this figure was even higher. Most of the subprime mortgages were packaged in the form of mortgage-backed securities (MBS) and collateralized debt obligations (CDO). These loans were offered by both small banks and large firms such as Freddie Mac, Fannie Mae and others.

So what went wrong that led to the mortgage crises of such a magnitude?

You may have heard of the saying that excess of anything is harmful; the same happened in the real estate market. Property values that had been rising since the 2000s declined steeply in mid-2006, due to the fact that many people were not able to refinance their loans. As property values declined, the adjustable rate subprime mortgage began to reset to higher rates, consequently causing monthly mortgage payments to rise, resulting in a soar of delinquencies nationwide.

Banks wrapped with subprime assets suffered a major blow when people started to default on their loans in large numbers. Decreases in house property values brought down the value of mortgage backed securities to an extent that large financial institutions, such as Bear Sterns and Lehman Brothers had to shut down their operations.

How the Mortgage Crises Affected Individuals?

The mortgage crises had a far reaching impact on the economy. Many major financial institutions such as Merrill Lynch, Fannie Mae, Freddie Mac, and others had all come within a whisker of going bankrupt and had to be rescued. This caused a great disruption in the flow of credit to the companies and consumers that created a recession which lasted from December 2007 to June 2009.

Decline in credit availability led to reduction in consumer spending and subsequently business investment. In order to reduce operational costs, companies had to shed their workforce due to the fact that a large number of people were losing their jobs. Around 9 million individuals had been laid off in just one year, between 2008 and 2009, which represented 6% of the workforce.

The subprime mortgage crises had far reaching consequences not just in the US, but all over the world; however, this could have been averted if securitization had been checked. Today the economy of the US is a shadow of its pre-crisis level. According to economist Paul Krugman, the economic prosperity experienced before the subprime mortgage crisis depended on the housing bubble, replacing an earlier and huge stock bubble. Since the housing bubble does not seem to be coming back, the spending to sustained economy like the pre-crisis years isn’t coming back either.