: what was the subprime mortgage crisis ?
In: 4
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.
Latest Answers