Question

Explain how subprime and, sometimes, “zero doc,” loans, contributed to the Great Recession of 2008-11.

Keynesians had argued that monetary policy might not prove effective enough in bridging a recessionary gap, I.e., guarantee enough spending to get an economy out of recession, and the Great Recession of 2008-2011, seemingly, helped prove their point. True, the downturn in business activity was atypical of recessions commonly resultant from either too little demand or excessive aggregate supply levels. Nonetheless, monetary policy had one “heck of a time” trying to bring about full employment/output, and it wasn’t just the Federal Reserve involved but the Bank of Japan, European Central Bank, the Chinese central bank, often coordinating their efforts by injecting cash into their banking systems in hopes of turning the corner of global recession.

So, to paraphrase Don Corleone in Godfather, Pt. I when speaking to the heads of the other syndicate families in hopes of brining a tumultuous gang war to a close, “how did things get so far?” Or, how did the world become encompassed in this significant fall off in business investment and consumer spending not seen since the Great Depression? Complicated, but we’re going to provide you with as much lucidity as possible regarding the matter…and away we go!

Banks originate loans meaning they lend money to those who want to purchase a home, simple enough, eh? Now, when, say, Bank of America, has originated (lent out) so much in loans, to raise more money, it will package so many hundreds of thousands of loans for resale to Secondary Market Participants. These entities consists of quasi-government agencies known as Fannie Mae (Federal National Mortgage Association), Freddie Mac (Federal Home Loan Mortgage Corporation) and Ginnie Mae (Government National Mortgage Association). And you just thought that banks accepted deposits -and demand deposits- along with charging fees to raise money, oh contraire! The Secondary Market was, and still is, essential to banks’ operations given that they are purchasing thousands of dollars in loan packages the proceeds of which Bank of America, Chase, Wells Fargo use to originate more loans. Often banks will retain the servicing rights of the loans they originate (collect principal and interest payments) even after the loans have been packaged for resale. Also, sometimes other banks -not FNMA, FHLMC or GNMA- will purchase one another’s loans, or a loan company, like a Quicken Loan out of Michigan, while not a bank, will sell an aggregate amount of loans to raise more capital.

…and where do the Secondary’s obtain their funds? Well, once the loans are purchased they are securitized into bonds, credit instruments which FNMA, FHLMC and GNMA, Fannie Mae, Freddie Mac and Ginnie Mae, respectively, issue to borrowers. In turn, the secondary’s agree to pay interest on these securities to the bondholders who purchased the bonds. Let me say it more clearly…borrowers take out loans offered by the banks…the banks, to raise more money, bundle these loans and sell them to Secondary Market Participants; banks, as a result have more money to lend. The Seconds need to get cash, too, so they take the loans, bundle them into what are called Mortgage Backed Securities (MBS’), or bonds, and sell to investors desiring such instruments. The bond buyer is paying the Secondary who then has more money to buy loans from the banks, who have more money to lend…get the picture?

Furthermore, it wasn’t just mortgage loans that were securitized and sold as bonds to private investors but loans on cars, equipment, and other assets of which interest was paid. All worked pretty well for quite sometime until the real estate boom, which had begun around 2004, began to wane significantly by late ‘07. Record low interest rates brought to us by the Fed -the Fed sets short term interest rates- and with yields on ten year Treasury bonds low as well since the attacks on 9/11, home purchases skyrocketed. Banks even made “Zero Doc” loans, meaning “it’s ok, we know you’ve got enough income because you’ve got a job, we don’t need much verification on any other collateral you have -at least, we hope you’ve got more collateral.” Sometimes even 100% financing occurred whereby banks offered loans lending amounts up to the purchase price of the property with no money down! Plus, many of these loans were "subprime," meaning lenders would offer loans to borrowers who didn't always have stellar credit; think of getting a loan for a home with a below 650 FICO score. Remember, the banks are just going to unload this paper anyway to the Secondary’s so it isn’t like there are risking too much, right? An unbelievable time it was…and then…what goes up…must come…

By ‘06 the real estate market across the U.S. began to cool down, as did the economy. When folks started losing their jobs they couldn’t pay their mortgages (home loans). Stay with me…those who purchased mortgage debt (MBS’) recognized that their bonds were losing value when they logged onto their accounts at investment houses such as Shearson Lehman, Smith Barney and others. The bonds are losing value because the loans they are securitized by, many of which, are now in default! “Ok, I’ll just sell my bonds.” Well, that will only make matters worse for the oversupply will force prices down and cause interest rates to rise (I’ll explain this part a bit later). However, the interest was paid by the Secondary’s; that’s an obligation of any entity that sells bonds: interest must be paid and principal (the loan amount) retired when the bonds mature (come due). Back to the crisis…

Answer 1

Let us understand in simple terms about subprime crises role in global recession of 2008

1. Loans were given to individual with NO income, no jobs, no assets (Ninja Loan)

2. Loans were given to purchase housing property.

3. These loans were converted into marketable securities and sold to International investors.

4. When home buyers started to default on emi payments.

5. Banks also started to default on payments on marketable securities to International investors.

6. The value of house/ property which was a collateral for a bank has started to depreciate very quickly.

7. With massive defaults from home buyers on emi payments, the construction industry started to slow down.

8. When banks try to liquidate houses which were collaterals, the value has decreased to negligible amount as there were no takers for houses.

9. As news came about defaults on part of buyers and bank, the stock market crashed.

10. Slowly entire world economies started to slowdown.