What Occured

The Subprime mortgage problem is believed to have started as early as the year 2001, but just didn’t catch up with the market until August of 2007. It is believed that it can go back to this year as this is when the Federal Reserve lowered the interest rate to 1%, which was the lowest in years. This encouraged many buyers to take out large mortgages to fund the “American Dream” and purchase a home to call their own, but just how costly it would prove to be for them no one could predict. They believed that they would be able to benefit from the low interest rates and that house prices would always rise, and never fall. The graph below shows how the prices have risen since 1990 until 2007 and then when the markets realised what was happening there was a dramatic deterioration in prices.

Figure 1 Median U.S. Home Price: 1990–2008

Source: Federal Reserve System

The loans that were affected the most were the variable mortgagees based on short term interest rates, which enticed borrowers with their initial very low interest rates, which were highly responsive to Federal Reserve policy. Prime mortgages went to the better off, and sub-prime mortgages to people who had never qualified for a mortgage before.  Banks were writing mortgages for customers who previously would have been classified as being at a high risk of not repaying with poor credit ratings. Surely this was not practical as the smallest of change in the interest rate would indicate these customers would be unable to keep up with the payments. This was exactly what happened and by the time interest rates were starting to raise in 2004 many borrowers were unable to repay their loans. When it got to the stage when borrowers were unable to keep up with their mortgage repayments an alarming number of homes were repossessed causing the property bubble to burst, which caused the large fall in house prices.

Behind the scenes the banks were involved in dealings that no one else knew of. The US banks were parcelling together different types of mortgages and selling them off to investors. These parcels were notoriously known for paying a high rate of return at a time of low interest rates which was very appealing to large investors. The real problem with the way they were being securitised was that respected names were endorsing these loans so no one questioned the quality of the packages, but in reality Sub-prime mortgages were being disguised as first class assets.

The ratings agencies had a huge part to play in the sub-prime mortgage events because of the ridiculously high ratings that many of the parcels were receiving, and when they finally decided a dose of reality was needed they issued downgrades for sub-prime linked debt. This had to be done, but it brought to light even greater debts that anyone could have imagined and highlighted just how toxic some of the securitised parcels were and this is when the panic began as no one wanted to be left with the parcels.

In my next post I will be looking at who lost out throughout the crisis.