Subprime Crisis - My Take - Cause & Origin

THE CRISIS:

The financial crisis of 2008, popularly referred as “subprime mortgage crisis”, resulted in losses in billions throughout the world. The toll also included few of the most reputed and successful companies of the financial industry. The regulators and the government failed to contain the crisis within the premises of the mortgages which were overloaded with the subprime loans. The fallout was so severe that it not only had sublime effect on US economy but also led to the one of the worst global recessions which had not been recovered.  The exposure to the subprime assets and the gradual loss of confidence in various asset classes was the reason of the spread of crisis to other economies.

Causes and Origin of the Crisis:

Liquidity Bubble caused due to low interest rates:

After the collapse of dotcom bubble in 2001, the US government reduced the interest rates sharply from around 6.5% to 1% to stimulate the economy. Japan too, in order to recover the economic slowdown in 1990s, cut the interest rate to 0%. Low interest rates and zero-equity loans made borrowings extremely cheap and also helped pushing the house-prices higher since loans were available to lower income households. Besides, many countries experienced a huge increase in wealth and were willing to invest it. One of these countries was China which heavily invested in US wealth funds. Overall, this pumped a lot of money in the financial system where potential returns were higher. This, in a nutshell laid the ground for the financial crisis. 

Toxic Mortgages:

There was emergence of a new kind of specialised mortgage lenders in the boom period. With rise of such unregulated lenders, there was also rise of different kinds of mortgage loans such as adjustable rate mortgages, interest-only mortgages, stated-income loans and NINJA loans (no income no job and assets). These loans were provided without any documentation required to authenticate the income or without having to prove any owned assets. Likewise, the mortgage qualifications for loan eligibility were diminishing. These subprime lenders, mostly not operating under the federal banking laws of consumer protection, increasingly targeted the undeserved borrowers. Thus, the risk of defaulting the loans increased significantly.

Residential Mortgage-Based Securities Vs Other Securitised Assets in US

                                      

 Credit-rating Agencies and Investment Banks:

The investment-grade ratings given to these securities by reputed credit-rating agencies were flawed. Many of these mortgage-backed securities (MBS) were rated AAA, generally given to highly reliable and trusted securities like US bonds. Giving high ratings to such products was highly profitable. Besides, the government-sponsored agencies like Fannie Mae and Freddie Mac issued more than half of these MBS’s. Even the investment banks were the underwriters of many private-label securities (PLS) which were very risky. These investment banks took a lot of risks with the borrowers’ money.