How it all started?
Traditionally what was followed in the US market was mortgage lending through deposits which were made by the customers. The deposit ratio in the banks was low. The banks would check the credit history of the customer and their capability to repay the loans.
Now, as the banks wanted to expand their market share they came up with the concept of sub–prime lending in the early 2000s. Sub prime lending is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. Subprime lending is risky for both lenders and borrowers due to the combination of high interest rates, poor credit history, and adverse financial situations usually associated with sub prime applicants.
What went wrong due to subprime lending can be explained with help of the following diagram:
Reasons for the US Subprime Crisis
Low Financial Literacy
The first ingredient of the crisis is a blend of bad information, financial inexperience and myopia of consumers/investors. They fell for the prospect of getting a mortgage at rates never seen before and then extrapolating these rates out for thirty years. This myopia was encouraged and indeed exploited by banks and other lenders eager to attract and retain clients. Financial literacy is low in the US. Only two out of three Americans are familiar with the law of compound interest; less than half know how to measure the effects of inflation on the costs of indebtedness. Financial literacy is particularly low among those who have taken out sub prime mortgages. The intermediaries exploited this financial illiteracy.
The second ingredient is the pace of financial innovation during the last ten years and the securitization that it produced. Today it is easy to "liquefy" a portfolio of illiquid credits (typically a combination of bank loans or mortgages) so they... [continues]
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