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• How did US Subprime Mortgages Cause a Global Financial Crisis?

How did US Subprime Mortgages Cause a Global Financial Crisis?

After the dot com crash and September 11, the US central bank, the Federal Reserve, cut interest rates to 1% to stimulate the US economy out of recession by encouraging spending and investing. Credit became widely available and the banks couldn't lend all of the money they had, so they turned to a new group of borrowers called subprime borrowers because they had poor credit history. The banks charged a higher interest rate for these borrowers and earned a higher return than from their traditional borrowers. However, with the higher return came the higher credit risk of the subprime borrowers.

The low interest rates cause house prices to rise sharply. This led to speculation on housing by investors and overbuilding by developers, which resulted in increased lending and leverage. There was also a surge in homeowners who refinanced their loans to tap into the increase in the equity in their homes.

To raise more funds for lending, the banks have traditionally created mortgage backed securities by pooling prime loans together and selling these securities to investors. The mortgage backed securities paid investors a regular income from the mortgage repayments of the underlying mortgages, and were backed by the underlying real estate. Eventually the subprime loans were pooled with the prime loans in tranches and securitised as well. These securities were known as collateralised debt obligations (CDOs) and were bought by hedge funds, pension funds, other banks and investors from around the globe. The credit rating agencies gave these securities their highest ratings and investors piled into them for their relatively high returns in a low interest rate environment.

The main problem for investors in mortgage backed securities and CDOs was the severing of responsibility of the original lenders. They retained no risk for the loans they made, but collected substantial fees for originating the loans, and as a result, lending standards deteriorated. For example, loans were even made to people who did not have jobs (such as NINJAs - no income, no job and no assets) and could not afford to repay the mortgages. To entice borrowers, many of the loans had low initial payments that increased over time.

Things started to go pear shape in 2006 when interest rates rose. New house sales and house prices started to decline, and the subprime loans made one or two years earlier had their low teaser rates reset to normal levels, which caused default rates to rise sharply. Then came the downward spiral. As repossessions increased, vacancy rates rose, which caused house prices in the surrounding area to fall further. In addition, as house prices fell, borrowers could not refinance their loans when repayments increased, which led to further defaults.

The investors in the highest risk tranches of the CDOs started to make big losses as defaults rose. However, none of the banks or other institutional investors admitted to any losses initially. Because no one knew who held what, the banks stopped lending to one another, worried that their counterparts would be unable to repay the loans. Mortgage lenders such as Northern Rock in the UK and RAMS in Australia that relied on short term funding from the money markets for their long term mortgages, could not roll over their financing arrangements. When news spread of the UK central bank, the Bank of England, stepping in to assist the Northern Rock, there was a run on the bank as depositors tried to withdraw their savings before it collapsed.

There was also a flight to quality as the yields on government securities fell, while the spread between government and corporate securities widened sharply. With many institutional investors highly leveraged, the increase in borrowing costs caused some of them to collapse, while others faced margin and collateral calls. This forced them to sell their liquid assets, such as shares, to raise cash. This pushed share prices down and resulted in further margin calls, and more forced selling. Within a few weeks, many stock markets around the world had fallen to nearly half of their highs in 2007.

In summary, it all started with the Federal Reserve holding interest rates too low for too long, which led to the US housing bubble. This was compounded by the banks lending to borrowers who could not afford to service the mortgages, and investors who bought securities backed by these mortgages without understanding the underlying risk. When US house prices fell, and defaults soared, the investors in these securities suffered large losses, which spilled over into the stock market. And finally greed turned into fear - once the banks couldn't lend enough to even high risk borrowers, during the global financial crisis, they restricted credit to even the most credit worthy borrowers. So while it was greed that precipitated it, it was the swing in sentiment to fear that really caused the global financial crisis. If sentiment had just swung back to neutral, then we would still have the collapse of the US housing market, but nothing like the global financial crisis.