Question

The 2008 sub-prime mortgage crisis in the United States could have been mitigated by applying prudent credit management. Identify and explain the main causes of the crisis.

Answer 1

Subprime mortgage crisis:

Subprime lending is defined as lending money to someone who has trouble in repaying it. On the other hand subprime mortgage is a home loan that is sold to someone who is not likely to keep up the monthly payments.

Hedge funds, banks, and insurance companies caused the subprime mortgage crisis. Hedge funds and banks created mortgage-backed securities. The insurance companies covered them with credit default swaps. Demand for mortgages led to an asset bubble in housing.

When the Federal Reserve raised the federal funds rate, it sent adjustable mortgage rates sky rocketing. As a result, home prices plummeted, and borrowers defaulted. Derivatives spread the risk into every corner of the globe. That caused the 2007 banking crisis, the 2008 financial crisis, and the Great Recession. It created the worst recession since the Great Depression.

• Hedge funds played a key role: hedge funds were under the pressure to outperform the market. They created demand for mortgage backed securities by pairing them with guarantees called credit default swaps. Those with adjustable-rate mortgages couldn't make these higher payments. Demand fell, and so did housing prices. When they couldn't sell their homes, either, they defaulted. No one could price, or sell, the now-worthless securities. Deregulation was also one of the reasons. In 1999, the banks were allowed to act like hedge funds. They also invested depositors' funds in outside hedge funds. That's what caused the Savings and Loan Crisis in 1989. Many lenders spent millions of dollars to lobby state legislatures to relax laws. Those laws would have protected borrowers from taking on mortgages they really couldn't afford.
• Derivatives: Banks and hedge funds made so much money selling mortgage-backed securities; they soon created a huge demand for the underlying mortgages. That's what caused mortgage lenders to continually lower rates and standards for new borrowers.

• Subprime & interest only mortgages don’t mix: Subprime borrowers are those who have poor credit histories and are therefore more likely to default. Lenders usually charge higher interest rates to provide more return for the greater risk. Generally, that makes it too expensive for many subprime borrowers to make monthly payments.

The advent of interest-only loans helped to lower monthly payments so subprime borrowers could afford them. It increased the risk to lenders, however, because the initial rates usually reset after one, three or five years. But the rising housing market comforted lenders, who assumed the borrower, could resell the house at the higher price rather than default.