: what was the subprime mortgage crisis ?
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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.
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