: what was the subprime mortgage crisis ?
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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.
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