The Subprime Mortgage Crisis (2007-08)

House prices in the United States increased 124% between 1997 and 2006.

IIt ranks among the most catastrophic financial events in U.S. history, and its eventual impact on the global economy means it occupies a prominent place on the world stage in terms of systemic importance. But what caused the subprime mortgage crisis and how did it lead to one of the most dramatic global economic contractions of all time?

In short, the subprime mortgage crisis was caused by the bursting of the bubble that had formed in the booming US real estate market and which peaked in 2006. This boom, combined with low interest rates at the time, meant that lenders were keen to expand their portfolios. loans to borrowers with bad credit histories, which ended up triggering a wave of defaults across the country as the economy slowed and fell into recession.

The economic history of the first half of the 2000s is indeed that of a rejuvenation following the bursting of the Internet bubble at the very beginning of the decade, followed by the shock of the attacks of September 11, 2001 against the World Trade Center in New York. York. . And with the growing risk of deflation looming, the Federal Reserve (Fed) has aggressively cut its benchmark federal funds rate from 6.5% in 2001 to just 1.0% in 2003. low rates, however, have resulted in substantial growth in real estate. demand because it costs less for buyers to take out mortgages. This demand has caused housing prices to skyrocket; According to the S & P / Case-Shiller US National Home Price Index (CSUSHPINSA), house prices in the United States increased 124% between 1997 and 2006.

“Determined to revive growth in this potentially deflationary environment, the FOMC [Federal Open Market Committee] adopted a policy of ease and promised to keep rates low. A few years later, however, after the inflation figures underwent a few revisions, we learned that inflation had in fact been half a point higher than expected, ”Richard W. Fisher, President and Chief Executive Officer (CEO) of the Federal Reserve Bank of Dallas, noticed in late 2006 ( “In retrospect, the actual fed funds rate turned out to be lower than what was considered appropriate at the time and was kept lower than it should have been. In this case, poor data led to political action that amplified speculative activity in the housing market and others.

And while other markets such as Spain and the UK experienced similar real estate booms during this time, the nature of the US real estate boom was markedly different. Specifically, the composition of home buyers consisted of a significant number of less creditworthy borrowers with poor credit histories. These borrowers were generally refused loans from traditional lenders, but were eligible for subprime loans, i.e. higher interest rate loans given to borrowers with low credit ratings, and were charged at higher rates on home loans than on standard mortgages. A significant portion of mortgage lending was also represented by existing homeowners looking to refinance and capitalize on lower interest rates to extract equity from their homes.

But these weak borrowers were exposed to complex and risky financial products, the costs of which could change dramatically with transitions in economic conditions. Indeed, the real estate and credit booms have sparked particular global interest in US Mortgage Backed Securities (MBS), financial contracts whose value depends on mortgage payments and house prices, comparable to funds comprising baskets. home loans that pay periodic interest rates. This means that the global exposure to the US real estate market has increased significantly during this period. But investment firms would buy substandard loans, such as subprime loans and NINJA loans (no income, no job, no assets, no problem), and restructure them into MBS products and other complex credit-related products, such as secured debt instruments (CDOs) to be marketed to investors around the world.

“What was peculiar to America was the ability of a large number of subprime borrowers – those with poor credit records – to take out mortgages and buy homes, attracted by good credit. market and the conviction that house prices could only increase ” Noted The Economist in October 2007. “In 2006, a fifth of all new mortgages were subprime. The interest rates on many of them were adjustable, unlike those on most American mortgages. Low “teaser” rates were charged for some time before higher, market-based rates came into effect. “

The boom in loans and housing also sparked a boom in housing construction, which ultimately led to an oversupply of unsold housing in the country. To prevent the economy from overheating, the Fed further started raising interest rates from 2004, when house prices were still rising, reaching 2.25% by year-end. and continuing in 2005 to reach 4.25% in December. In June 2006, and under the leadership of its new chairman, Ben Bernanke, the Fed raised rates to 5.25%, which had already done a lot to cool the housing market.

In September 2006, house prices fell on an annual basis for the first time in 11 years, with the National Association of Realtors (NAR) Reports Median prices for existing home sales fell 1.7% from the previous year, the largest percentage drop since November 1990, when the United States was in the midst of a recession. Excess housing stock played a significant role in this decline, with unsold stock reaching 3.9 million, a 38% increase from 12 months earlier. This gave the market a 7.5-month housing supply, which was significantly higher than the 4.7-month supply available in August 2005 and the 4.3-month average supply throughout 2004.

Many thought the housing market was cooling down and was simply experiencing a healthy correction at this point. Few have realized the extent to which subprime mortgages exist and exert an influence in financial markets, primarily through MBSs which frequently repackaged subprime mortgages for global investors and were repeatedly resold across the country. the financial system and, ultimately, the economy as a whole.

Indeed, the rate-tightening cycle ended in disaster for those holding subprime loans. The sharp rise in mortgage rates triggered defaults across the country as weak borrowers failed to pay off their home loans. In November 2006, the slowdown in housing demand in the United States resulted in 28% fewer new permits than a year earlier, strongly indicating an impending increase in housing closings. And with the economic contraction that accompanied rising unemployment rates, a growing number of borrowers have lost their jobs, which has only worsened their ability to repay their mortgage obligations.

The losses suffered by Merrill Lynch on CDO products led to the sale of the company to Bank of America.

With many borrowers defaulting and foreclosing on their mortgages, banks therefore quickly began to accumulate substantial volumes of bad debt on their balance sheets. In October 2007, for example, Merrill Lynch’s third quarter earnings showed a loss of $ 6.9 billion on CDOs and a loss of $ 1 billion on subprime mortgages, which in total was the biggest depreciation on Wall Street at this point, almost double the $ 4.5. -billions in losses the bank had told investors to expect just three weeks earlier. Days later, Merrill Lynch CEO Stanley O’Neal resigned.

As the economy plunged into recession, banks suffered massive losses, unable to sell foreclosed properties at the prices borrowers paid when they took out their loans. Many banks suffered huge losses, forcing some to close, such as the 150-year-old Lehman Brothers; taken over by other lenders to save them; or bailed out by the government under the Troubled Asset Relief Program (TARP).

After the US federal government decided Lehman Brothers was not “too big to fail,” the impact on financial markets was seismic as investors sold assets in virtually every market. In addition, money has been withdrawn en masse from banks and investment firms, which in turn has had a drastically restricting impact on the financial industry’s lending capacity. Indeed, banks have implemented stricter credit limits, freezing access to credit for businesses and consumers, plunging the economy into a deep recession.

Ultimately, the diffusion of subprime mortgage products throughout the financial system – and in a climate of weak regulatory oversight – was the key factor in creating the global financial crisis. These exotic products were too complex for the ordinary investor to fully understand, and they invariably depended on an endless environment of low interest rates and high real estate prices. But as soon as this was not the case from 2006, subprime mortgages turned into a crisis and ultimately into a global economic collapse.

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An excellent documentary on the subprime crisis.