: what was the subprime mortgage crisis ?
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In an effort to encourage more people to buy homes, politicians passed feel good legislation that loosened lending requirements. This allowed people who previously couldn’t qualify for a home loan to be able to get a mortgage and buy a home. The loans were considered sub prime because they were given to people with less than prime credit scores and income. When the economy had a down turn many of those sub prime lenders were no longer keep up with their payments.
Of course politicians always blame others for their mistakes so they started blaming the mortgage companies (banks) The problem with their complaints is that the same politicians decoupled the mortgage process from the mortgage companies. So you had. And still have mortgage brokers creating the loans. Then many mortgages are bundled and sold to a lender like a big bank.
So suddenly when the economy went sour these banks, especially smaller banks were saddled with unrecoverable debt and many started to go bankrupt. When a FDIC insured bank goes bankrupt, the federal government is required to step in and repay the customers. As you can guess, it would be very expensive for the tax payer if a bunch of banks went bankrupt. So one solution, rather than spend huge sums of money on failing banks, some big banks large sums of money to buy the toxic mortgages from the smaller banks. By allowing smaller banks to off-load their bad loans, it kept them from going bankrupt and saved the federal government lots of money. The big banks, because they have more assets were able to administer the mortgages without going bankrupt.
Of course the same politicians who reduced lending requirements, decoupled mortgage brokers from the actual lenders and blamed then blamed the problem on mortgage companies and lenders then attacked the solution as a bail out for big banks.
Banks started lending money to home buyers who could not afford it.
And they did it because housing prices kept rising.
You would go to the bank and get a mortgage then fix or just sit on the house for a year or 2 then sell it for big profit…
Banks even had negative interest loans. With these you owed more money every month than you paid in.
The crisis was when suddenly houses stopped going up in price and actually dropped.
Suddenly people who couldn’t afford the mortgage now owed more money than the house was worth.
Now banks had to foreclose and repossess and sell the house. But the house is worth less than they lent out.
Since this kept happening housing prices dropped more because suddenly hundreds /thousands of houses were on the market after foreclosure.
Because the housing market kept dropping even more people who took out loans owed more on the loan than the actual value of the house.
* Home loans (mortgages) represent a steady stream of income for the debt holder.
* Banks can sell mortgages – they get their big chunk of cash back now to use again, and the buyer gets a steady income stream over a couple of decades.
* Buying a single mortgage is a little risky, as any given homeowner has a risk of defaulting on the loan
* Buying a single mortgage is also more than people might want to spend all at once.
* However, if instead of buying one whole mortgage, the bank splits a thousand mortgages into a thousand strands, this fixes those two problems – the risk of any default is greatly diluted, and you can buy any thickness bundle of strands you want.
* Hooray! Everyone is happy!
* This gives the banks a *huge* incentive to give out mortgages to absolutely anyone. They sell the risk to other people, and they can make a nice little return on their loan – and they can keep doing it over and over.
* This incentive means banks bend, break and just flat-out ignore all the rules about responsible lending, and give home loans to people who are never going to be able to pay them back.
* *Millions* of them.
* Now those bundles have a *large* percentage of dead strands, of loans that are never getting repaid. Those bundles are worthless, they’re dead assets, they’re worthless as collateral.
* So the banks conveniently don’t mention that.
* The banks also cook up a whole new product – they split up the bad bundles and remix them back together into new bundles, and now it’s a fresh *new* product and the risk is defined as being diversified, so it’s considered premium quality again.
* Now millions of investors across the country have sunk all their money into worthless investments, and *used those investments as collateral on loans*.
* Eventually, the loans come due, and enough people default on their loans… and everything turns to shit.
* All the investors now have nothing.
* All the loans the investors took out using the bundles as collateral… are now unsecured
* Banks *cannot* have unsecured loans. They’re absolutely not allowed to – it constitutes fraud to loan out their customers’ money without a guaranteed way of getting it back.
* Oh fuck.
* Now everyone wants their money out of the damn banks before they go under – and this drags them under.
* fuck fuck fuck fuck fuck
You should watch *The Big Short*, if it’s still on Netflix.
It goes into the whole thing in a lot of detail.
Mortgages all come with a risk the borrower won’t pay. Someone with a low-paying, insecure job and a history of missing payments on loans will probably have a low credit score, meaning they’re more likely not to pay. Subprime mortgages are mortgages given to people with lower credit scores.
If I lend you money to buy a house, it’s possible for me to sell that mortgage on to someone else. Let’s call them ABC Finance. I get money now, and ABC Finance gets your repayments. In the US, a high proportion of mortgages were sold like this.
What this means is that ABC Finance now takes the risk on your mortgage. If you don’t pay, they lose out.
If the mortgage is a “prime” mortgage, they also have a nice, low-risk asset and they can borrow more money against that asset (which they might use to finance more mortgages!).
But what if it’s subprime? Well they *might* still want it, but it’s higher risk, so not as good an asset, and they won’t pay me as much for it.
Here’s where a smart/terrible idea comes in. What if I sell big bundles of mortgages selected in a way that makes the overall risk is low? So, for example, people in New York might miss their mortgage payments if there’s a downturn in the financial industry, and people in Kentucky if there’s a bad harvest. But what are the chances of both those things happening at once? A load of mortgages from New York or a load of mortgages from Kentucky are a bad risk, but bundle them together and the risk is a lot lower!
Now I can sell these high risk mortgages as low-risk bundles. In fact, I can get rating agencies to officially say they’re really low risk. ABC Finance gets a nice low-risk asset and I get more money for it. In fact, it turns out I can make more money selling subprime mortgages than prime mortgages.
So here a problem comes in: there’s an incentive for me to sell more and more subprime mortgages. Standards slip. I stop doing even basic checks on the people I lend to. And nobody really looks into these big bundles of mortgages, including the rating agencies who are supposed to be checking them. Everyone’s buying them, everyone is making plenty of money, everyone trusts them, so why go into the detail?
The really fundamental problem is that there are some things that can hit bank workers in NYC and farmers in Kentucky at once. Things like an economic downturn in the US, or like big problems in the financial sector. If something like that happens, these bundles of mortgages will crash in value. And that causes more problems because lots of lending is based on them being low-risk assets. So it can cause mortgage lending to slow and the financial system to start to seize up, which just makes things even worse and the mortgages worth even less.
And that is exactly what happened, kicking off a financial crisis that spread beyond the mortgage sector and beyond the United States.
The short version is that banks thought they had figured out this *one weird trick* to spread out risk so much that it wouldn’t matter ever again. Instead, what they had done was create a system where *everyone* was exposed to the risk but had no way of knowing how much.
Banks invented the “House Bond”, a type of bond which entitled the owner of the bond to a portion of the profit of a certain set of mortgages. Because banks *were* extremely risk adverse when it came to granting mortgages, the Housing Bond was seen as a low-risk, high return investment, and they sold extremely well.
However, there was a problem. The sales of Housing Bonds were so profitable that a bank could make money selling a Housing Bond even if the underlying mortgages associated with it were worthless. This created a perverse incentive and the banks started to give out mortgages to basically anyone. They even stopped doing basic due diligence and verifying that the people who got the mortgages could afford to payment. They created “subprime mortgages”, which had a much lower initial interest rate then a massive balloon payment later on. The lower initial rate allowed people who knew that they would not normally be able to afford a mortgage to get one, which the bank would use to make new housing bonds and make a massive profit selling. Unfortunately, most people who got subprime loans couldn’t afford the balloon payments, and their mortgages failed. If enough of the underlying mortgages fail, a housing bond fails as well. Since they were considered low-risk, a large number of investment and retirement plans used them as the backbone of their portfolios, and these failed as well.
This is bad, as people lost their homes and their retirement savings, but it gets worse. Crashing the housing market alone wouldn’t have been enough to trigger a global financial crisis. There is a kind of financial instrument call a derivative. Derivatives are complex and varied, but as an ELI5, they basically let people bet on other things in the market, *including other derivatives*. This meant that on top of the housing market was a massive set of derivatives, which then had another set of derivatives built on top of those, and even more derivatives built on top of those, etc, etc. This meant that the housing crash didn’t just crash the housing market, but the wider derivative market, including many derivatives that didn’t immediately appear to have ties to the housing market, spreading the crash and destroying many investment banks and firms.
Interest rates should reflect credit risk with lower rates for borrowers less likely to not pay back the loan and higher rates for borrowers more likely not to pay back the loan.
Historically, banks would interview borrowers and collect information on those borrowers to determine the borrower’s risk of not paying back the loan and the amount of money that they could borrow and reasonably be expected to make monthly payments on. That determination of risk would then allow the bank to offer a mortgage with an appropriate maximum and an interest rate that reflected the risk of the individual borrower not paying back the loan.
In the 80’s and 90’s financial institutions greatly expanded the practice of bundling home mortgages together and selling them to each other. This is called securitization. It was (and remains) a reasonable way for savings and loans to manage their risks that overall interest rates would rise (banks themselves don’t determine the direction that overall interest rates move – this is done by the Federal Reserve).
Prior to the crisis, some companies realized that they could write mortgages without doing any of the time consuming work of actually interviewing borrowers and reviewing the borrowers’ financial status (income, savings, other loans outstanding , etc.) These companies and banks realized that they could just write mortgages to anyone regardless of the borrower’s fitness as a borrower. They could do this because they could bundle them into a security and then sell them to some sucker who would then be holding the bag if one or more borrowers didn’t pay back the loan. Eventually, so many mortgages were granted to people who would eventually not pay back the loan that a full blown crisis of mortgage failure occurred.
Banks lent money to people who couldn’t afford to pay it back. Many of these borrowers had bad credit scores, unstable jobs, and lots of other debt. They were classified as “sub-prime” borrowers.
Then they would sell the mortgages to investors in big batches. so now the mortgage payments are going to the investors, instead of the original lender. these investments are called “mortgage backed securities” or “Collateralized Debt Obligation (CDO).
Some of those investors were major banks and huge investment firms.
But that’s risky, so some big investors got insurance, just in case the homeowners defaulted on their loans. This insurance was called “credit default swaps”. But the thing is, *anyone* could buy a credit default swap, even if they weren’t the owner of the investment. So some people just bought them as investments, rather than insurance, hoping to make money when the CDO’s crashed.
And they did crash. big time. and the investors who owned the CDO’s lost a lot of money. And the companies who insured those CDO’s couldn’t pay for those losses, and they also lost a lot of money.
This crisis happened because banks and regulators all bought into the incorrect notion that “real estate always goes up in value.”
Imagine you go for a home loan, and the bank tells you that you need to put 20% down. This means if you’re buying a $100K home, you need to pay $20K now and take out a mortgage for $80K, which you then pay off over the next 30 years. If you take out a loan you can’t pay, even in the early part of the loan, the bank can foreclose and take your house, sell it, and get their money back.
The reason you have to put 20% down is that it can take several months—even more than a year— for this process to play out, and the bank has to spend a lot of money to get you out of there. They want to make sure that after all those costs are totaled up, they’ve made money, or at least not lost any money. IOW, that whole time they’re spending your $20K to kick you out of the house you’re no longer paying for.
There’s also the value of the house to consider. If the value of the house goes down, the bank wants to make sure that the $20K you put down will not only cover their expenses to get you out and resell it, but also cover any drop in value.
Example: You take the loan for $80K on a $100K house and never pay, after a year the bank has spent $10K in legal fees to kick you out, $2K to fix up wear and tear on the home, and the house dropped $4K in value, so they can only sell it for $96K. So the bank has spent $16K on this situation, but in the end they still made $4K on the time you were in the house.
In the early part of the first decade of the 2000s, there were many parts of the country where real estate value was climbing 5–10% per year. This changes the math considerably. In this scenario, the banks realized that they could write a lot more mortgages if they relax the 20% down requirement, because a lot of people couldn’t come up with that downpayment. But if the house is appreciating anyway, then the bank is still covered. In this scenario, if you buy a $100K house that goes up 10% per year, and you put down only 5% instead of 20%, that means the bank’s downside on the worst case scenario is they spend $16K and can get $15K out of your downpayment + appreciation … but if they just hang on to the house another 6 months in an appreciating market, they’ll get another $6K out of it. So there’s really no risk to the bank to make loans with a lower downpayment. In fact, so many real estate markets were so hot that banks didn’t even care if you could pay or not, so they started giving “no doc” loans, meaning you didn’t have to provide documentation that prove how much money you’re making. They actually didn’t mind if borrowers defaulted on loans because that just means they get to come into possession of a quickly appreciating asset.
Now if you’re talking about one particular house, there’s still a lot of risk because weird market conditions can create a situation where there are no buyers for that particular house and it doesn’t go up in value like “the market” says it should. However, if you are a bank, you have a lot of these loans across a diverse range of properties, and all you care about is the average case, not any one in particular. So this creates the rationale for bundling all these loans together. They’re called “subprime” mortgages because the loans are risky; a lot of the borrowers can’t afford to pay them. However, that doesn’t matter if the house is going to keep climbing in value. (Never mind how unethical it is to make a loan to someone who can’t afford it…after all, that person’s life and credit will be wrecked in the aftermath, even if the bank can make money.)
The assumption that this is all based on is that demand is going to keep housing prices going up. This would have been a good assumption if all the demand was organic; that is, if everyone buying these houses was living in them. However, because they were appreciating, there was a lot of speculation going on. People and businesses would buy homes not for the purpose of living in them, but just to hold them for awhile and then flip them and make money. This, of course, created more demand, and caused prices to go ever higher. Over time, people who actually want to buy these houses to live in them get priced out of the market because they aren’t getting investors together to invest and flip, they’re just paying the mortgage out of their bank account, so they can’t compete with investors pooling their money together. The balance of buyers driving this crazy amount of demand shifted heavily toward speculators. This is called a bubble…when the demand shifts from organic to synthetic, stable to volatile, it can collapse all at once, and the basic assumption the entire system is based upon—that “real estate value always goes up”—is suddenly no longer true.
That’s the ground level understanding of all this stuff before all the complicated financial instruments come into play. The financial instruments are important to understand too, though, because these are what made it possible for all this nonsense to proceed. Generally speaking, bubbles like this can only go so far before the few participants involved in a transaction start to get worried. What these instruments did is increase the number of participants dramatically, and remove the people funding this process several steps from what they’re funding, so they don’t perceive that risk.
Here’s how it worked. Banks rolled together these risky loans into bundles, and then “securitized” them, turning them into bonds (“mortgage-backed securities”). Because “real estate always goes up,” these bonds got AAA rated by regulators based on the above argument that “even if everyone defaults, we take over the properties and they continue to go up and we sell for a profit.” This process of the bank taking responsibility for defaulted loans was put into the form of other financial instruments, the “credit default swap” and “collateralized debt obligation,” each of which allowed another repackaging of risk into tradable financial objects that got AAA ratings. Thus banks again would take these and sell them off to firms like Bear Stearns and Goldman Sachs. Other big buyers of these objects were pensions and 401K funds investing people’s retirement money which is usually put into very safe, AAA-rated investments, that pay lower interest than riskier investments. This high rating meant that holders could be paid lower interest rates for objects that are actually very risky, allowing investment firms and banks in the middle to collect the difference. Thus everyone along the way is motivated to continue doing what they’re doing as things spin farther and farther out of control.
Finally, after all this was set into motion and running for many years, too many homeowners started opting out by not paying, and there were no longer enough buyers left to keep demand propped up, as prices had gone too high in this speculation spiral. Suddenly, everyone began to realize they were holding bonds that would not pay out, and they would lose their investment. The biggest holders of these instruments went out of business or had to be bailed out by the government.
A “subprime loan” is a loan that has a higher interest rate because the person borrowing the money doesn’t have a good credit history and/or job. The bank assumes they have a higher risk of not repaying the loan, so they charge the higher interest. The crisis happens when so many people aren’t able to pay back the loans that the bank actually starts to go into debt. With a mortgage or car loan they can often get some money back from auctioning off the asset, but even then the bank might still be in the red. Eventually after enough bad loans, the bank’s investors will start losing money because those banks are losing money.
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