Subprime Mortgage Crisis: An Introduction

As Safe As Houses!

“As safe as houses”, this phrase is often used in our society. A house is supposed to be the safest place than one can be. Also, until 2008, most Americans and also most people worldwide considered this to be true of investments. A house was about as safe as an investment can get. It used to have a steady compounding rate of appreciation. The growth was nothing spectacular, rather just safe and sound cash flows that came in like clockwork.

True, that the average person had heard about housing market booms in some distant past. However, almost no-one had seen or experienced one very recently. Hence, although stocks, bonds and other investments being traded on the market were viewed as risky, a house was a different matter altogether.

This was about to change in 2008, with the bust of subprime mortgage crisis. The market may not have realized it. However, the houses were not safe at all. It turns out that the houses were built and sold on the basis of some very dubious lending practices. This is the reason why the study of subprime mortgage crisis is necessary for anyone studying asset bubbles.

Magnitude of the Crisis

United States and the world may have seen many housing crashes. However subprime mortgage crisis was distinctly different on many counts.

Firstly, it was the biggest bust of any kind that the world had seen since the Great Depression of 1929. This places in the category of the worst financial events that the world has ever witnessed.

Secondly, the crisis did not stay local to the United States. The subprime mortgage crisis became a worldwide phenomenon. Hence falling housing prices and rising delinquencies in the US became the cause for a worldwide recession and slowdown.

Thirdly, the crisis did not stay concentrated to the housing or banking sector. Rather, the crisis became an underlying economic current which caused bankruptcies of major corporations worldwide even though these corporations had absolutely nothing to do with mortgages or housing!

Ever since, the subprime mortgage crisis is used as a case study, a reminder of how interconnected our global financial system really has become.

Effects

The effects of the subprime mortgage crisis were too many to be listed down in this article. We shall have a detailed look at them in the module. However, just to provide a glimpse, this catastrophic event led to changes in the following areas:

• Banking: The subprime mortgage crisis has shaped the public opinion that banks are indeed working against the general benefit rather than for it. Many people had to lose their homes, suffer job loss and many such economic calamities unfolded because of what is perceived as a wrongdoing of banks built on their greed. Hence increasing public clamor against the perceived corruption of the banks led to increased regulation for the banking industry. Also the industry underwent severe change as some of the big players simply went bankrupt in the wake of the crisis. Mergers and acquisitions were rampant. If one looks at the banking industry in 2010, the big players are completely different from those in 2005.

• Financial Markets: The subprime mortgage crisis had a catastrophic effect on the financial markets around the world. Most indices lost their value by as much as 50% during the crisis. Stock markets were the worst hit and so were derivative markets. Also, as mentioned earlier this was not a local phenomenon. The tanking of stock indices was happening simultaneously in London, Tokyo, Hong Kong, New York, Singapore and any other major financial center in the world causing an atmosphere of unprecedented panic throughout the world.

• Political: Not surprisingly, a major financial event also turned out to be a major political event in the United States. The Republican government started being viewed as extremely pro crony capitalism and silently vetoing corruption. As a result, the Democrats and more specifically Barack Obama was catapulted to power. A lot of political programs were created with the intent to clean up the mess caused by the crisis. Also, a lot of money was spent on public welfare to ensure that people reeling from the effects of this catastrophe do find at least the basic necessities of life available.

• Main Street: The subprime mortgage crisis made life of the common man miserable. There was a high degree of resentment and the “Wall Street vs. Main Street” theme became common all over the media. There was increasing unemployment caused by the double whammy of recession and outsourcing. Also, with interest rates rising, the economy was on the verge of deflation. Consumer spending and consumer confidence index was at an all time low. This was one of the worst financial periods in history of the United States.

Raging Debates

The subprime mortgage crisis led to a lot of debates. Talk shows and newspaper columns were full of debates. Blame was being shifted from one group of stakeholders to the other. There were multiple hypotheses as to what caused this catastrophe. The government was forced to act on these theories and some pieces of legislation were passed or removed to make the financial system more stable.

Throughout the course of this module we will look at some of the most prominent theories and debates and make an attempt to analyze them.