The Big Subprime Bust

The subprime mortgage crisis is the biggest crisis to have hit America and the world since the Great Depression. Mega corporations like AIG, Lehman Brothers, Bear Sterns and Merrill Lynch fell to the ground whereas others like Bank of America and JP Morgan Chase found it hard to survive the fallout. The number of small and medium casualties across the world was countless. A lot of companies that had nothing to do with finance or banking also collapsed!

Now, since we know the buildup of the subprime mortgage crisis i.e. the major factors that seemed to have caused it, it is essential that we learn about how the crisis actually got triggered. This is an article about the turning point i.e. the point at which the markets stopped rallying and a bear run began. The events that caused the borrowing boom to change to subprime lending bust are as follows:

Runaway Inflation

The biggest contributor to the rising home prices was the artificially low interest rate that had been kept at around 2% for over 2 years! Now, it is one of the of the fundamental principles of macroeconomics that you cannot keep interest rates low for a very long time without suffering the consequences. The biggest consequence of low interest rates is runaway inflation. It is because of inflation that an economy cannot keep interest rates low for extended periods of time. Over the short run, lowered rates can help boost the economy. However, over an extended period, inflation will mandate that the rates be raised back again.

This is exactly what caused the Federal Reserve i.e. the central bank of the United States to make steep interest rate hikes. In a series of small hikes, the interest rates were raised to above 5% in absolutely no time. This was the knee jerk moment which would become the starting point of the domino that we now know as the subprime mortgage crisis.

Adjustable Mortgages Reset

Most of the mortgages that were sold in the United States were adjustable rate mortgages. This means that the interest rates on these mortgages were to fluctuate as per the prevailing interest rate in the market place. Also, mortgage payments are very sensitive to interest rate movements. A smaller change in interest rates leads to a bigger change in the monthly payments. It is for this reason that a lot of Americans suddenly found that their mortgage payments were simply unaffordable. With interest rates going from around 2% to around 5% in no time, the mortgage payments had almost doubled in this time frame. Most homeowners who had purchased the houses for purely speculative purposes did not have the robust cash flow that was required to support this.

The fact that a lot of these loans were teaser rate loans also contributed to the collapse. The interest rates were already low at 2%. Teaser rates meant that the borrowers would be given a lower than market rate for a specified period of time and then the rates would reset as per the market. Hence for many borrowers the shift was from 1% to 5%!

Delinquencies Galore!

The sudden and unprecedented rise in the interest rates unleashed economic mayhem on the country. Most homeowners were overly leveraged and did not have either the ability or the willingness to pay the monthly payments. Hence when times really went bad and their mortgages reset to the very steep market interest rates, these borrowers had no option but to be delinquent. Some of them were willfully delinquent. However, the majority simply went bankrupt. All the years of financial alchemy of making loans to people who couldn’t obtain a loan under normal circumstances went bust. The seemingly infallible model developed from sophisticated financial engineering simply went bust.

Prices Rock Bottom:

As and when delinquencies rose, more and more houses started hitting the market for sale. A lot of these houses were foreclosed by the banks and were being sold to recover the dues. There were other private parties who were selling their homes to avoid bankruptcy. However, almost everyone in sight was simply selling away their homes.

At a macro level, this created a scenario wherein there was excess supply and no demand to meet the supply. With interest rates rising and borrowing standards made strict, the liquidity had simply disappeared from the marketplace. Even borrowers who were genuinely interested in buying a house found it difficult do so because of the bank’s changed policies. This added to the depressed demand. All in all prices in the real estate markets hit rock bottom because of oversupply and no demand to meet that supply.

Shockwaves in Secondary Markets

The interconnectedness of the mortgage market made sure that the shockwaves felt in the mortgage markets were also sent to the other secondary markets. The majority of binds being sold at that time were real estate related. Hence, once the mortgage markets went kaput, so did the bond markets. A rising interest rates always cause the value of the bonds to fall. More so when the underlying security (the house) us rapidly losing value.

The shockwaves were felt all over the world. The next few months were simply historical from the financial point of view. A lot of financial giants simply collapsed, while others emerged bigger and stronger. Companies, municipalities and even nations were severely affected. The resultant fallout of the stocks, bonds, derivatives and the credit markets paralyzed the economy.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to and the content page url.