The subprime crisis, more famously known as the ‘mortgage meltdown’, came to public awareness when the drastic increase in home foreclosures grew out of proportion within a year, causing a domestic financial crisis within the U.S. which spread around the world in 2007. Many suffered as spending power of consumers diminished, housing market plunged, foreclosure numbers raised and stock market shaken as effects of the crisis. This resulted in violent conflicts among consumers, lenders and legislators over the sources and probable solutions to ease this mess. What caused the crisis and parties involved?
Real Estate Bubble (Home Buyers)
In the past, potential home buyers found it difficult to obtain mortgages if they had poor credit ratings, provided small down payments or sought high-payment loans. Unless protected by government insurance, lenders often denied such mortgage requests. While some high-risk families could obtain small-sized mortgages backed by the Federal Housing Administration (FHA), others, facing limited credit options, could only rent. During that time, homeownership fluctuated around 65 percent and mortgage foreclosure rates were low Owning a home has always been a part of the 'American Dream'. It allows people to take pride in a property and engage in a community for the long term. In the early 2000s, the conditions were right for people to achieve that dream. Mortgage interest rates were low, which allow homebuyers to borrow more money with a lower monthly payment. In addition, home prices increased dramatically, so buying a home seemed like a sure bet. Casual Underwriting (Lenders and Banks)
Soon, high-risk mortgages became available from lenders who funded mortgages when banks purchase those mortgages and repackaging them together with low-risk and med-risk mortgage into pools (subprime mortgage) that were sold to investors in the form of private-label mortgage-backed securities (Collateral Debts Obligations aka CDO) on the secondary market (Wall Street). This method allowed banks and lenders to pass the risk onto investors, and thereby loosen guidelines. Banks and lenders also relied on mortgage brokers and correspondents that were outside their own roof to provide mortgage loans. They incentivized bulk originating, pushing those who worked for them to close as many loans as possible, while forgetting about quality standards that ensured loans would actually be repaid. Because the loans were being sliced and diced into securities and sold in bulk, it didn’t matter if you had a few bad ones here and there. The less vulnerable of these securities were viewed as having low risk either because they were insured with new financial instruments or because other securities would first absorb any losses on the underlying mortgages. These enabled more first-time home buyers with minimal documentation or poor credit ratings to obtain mortgages, and homeownership rose. The resulting demand rocketed house prices, especially in areas where housing was in tight supply. This induced expectations of more house price gains, further increasing housing demand and prices.
From the diagram above, you can see that subprime mortgage grew from $173 billion in 2001 to a record level of $665 billion in 2005, an increase of nearly 300%. Inaccurate Credit Rating (Rating Agencies)
The belief that home prices would not decline was also fundamental to the structuring and sale of CDO. Therefore, the models that investment firms used to structure the CDO did not sufficiently account for the possibility that home prices could slide. Likewise, the ratings agencies assigned their highest rating, 'AAA', to many CDO based partly on the assumption that home prices would not fall. This had encouraged investors to purchase the CDO. Investors purchasing CDO profited at first because rising house prices protected them from losses. When high-risk mortgage borrowers could not make loan payments, they either sold their...
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