The Subprime Mortgage Fiasco Explained

The Subprime Mortgage Fiasco Explained

In 2001 Alan Greenspan at the Fed (Federal Reserve) lowered the interest rate to try to rejuvenate the economy after the fallout of the .com bubble burst. History will record that Greenspan went from the sublime to the ridiculous when he cut the interest rate to 1%. This set off a spate of irresponsible borrowing and lending the effects of which are still being dealt with today.The banks took advantage of this by starting to offer mortgages to subprime borrowers. Subprime borrowers are borrowers with a poor credit rating (specifically a FICO (credit) score of < 620). Typically these are individuals who habitually are unable to make credit card payments, or those who have suffered a foreclosure or bankruptcy. In the past they wouldn’t be able to get a loan, but thanks to the low interest rate, some could now afford the payments. With great fanfare out went the ads: “Send us your poor, your homeless, your great creditless masses!” Lured by the prospect of home ownership and lulled by the chimera of ‘buy now, pay later’, loans were issued as fast as the printers could print them.

Banks noticed that the default rates were lower than they expected. This led them to think that there was an untapped market in subprime lending. They developed many products, of which 3 were common 1) Variable rate mortgage with a higher rate due to the risk, 2) An interest only loan where they would start paying off the capital after an initial period and 3) low fixed rate initially, resetting to market rate after a few years.

The people who took these loans did so for two principal reasons 1) they hoped their income/credit would improve during the initial period of the loans and 2) the housing market was so hot, they hoped to use the newly gained equity in their homes to refinance the loans with more agreeable terms. Regrettably, Alan Greenspan, noting the now uncontrolled inflation, agressively started to increase the interest rates in 2004 right back up to around 5% and beyond.

For people with loans of type 1) and 3) above, the loans were typically huge so these interest rate increases made the payments impossible to cover, leading to defaulting. Those with loans of type 2) were pushed over the edge when the capital component of their loan kicked in.

Now, were it not for the avarice of the bankers, this crisis would have ended there; that is, a large number of repossessions but no further economic upheavel. However, bankers are weasels and behind the scenes they were pulling more ridiculous stunts.

Behind the scenes, bankers were looking to mitigate the risk of this subprime debt and also to make more profit on profit by creating and selling subprime mortgage bonds. To accomplish this they pooled together all subprime debt. Next they broke the subprime debt into levels. Suppose there were 3 banks involved in a given mortgage. The banks that would get hit by a default first were put into the lower levels and the banks that would be hit last were put into higher levels. By doing so, each level bore a reduced amount of the total risk. Now, many financial institutions that cannot purchase subprime debt were able to get around this limitation by purchasing bonds in the higher levels (less risk) of these mortgage bonds. Now, subprime debt was distributed all around the world to various institutions in this masked mortgage debt trading instrument.

So when the debt hit the fan, the big institutions which normally make loans to one another on a regular basis to keep the economy rolling, suddenly mistrusted one another. No one knew who held what amount of subprime debt. As a result the overnight lending rate went sky high and the Fed had to step in to push cash into the economy to help stave off a liquidity crisis — a crisis where cash flow starts to freeze.

At the time of this writing (Dec 2007) we are beginning to see the end result of this crisis. The large financial houses are beginning to crumble under the weight of their own stupidity. Just yesterday financial giant Morgan Stanley reported its first quarter loss in its 73 year history. Even more alarming, in seeking to assuage their woes, not only are they turning to the US government for help, but have successfully enlisted the help of the Chinese Government.

What may not be obvious, but should have the reader seeing red is that as the result of the irresponsibility of US financial institutions, we’re witnessing a wide scale buy out of US assets and institutions. What’s more, who speaks for the countless duped masses who have lost homes, equity and security as the result of this mass irresponsibility? There can be only a partial answer in paraphrasing Herbert Hoover who said: “Older men declare war. But it is the youth that must fight and die.” In this situation it is the financiers who tinker with the economy. But it is the working class that must work and suffer.

3 thoughts on “The Subprime Mortgage Fiasco Explained

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.

Back To Top