The subprime mortgage crisis has put the U.S. economy into the worst recession since 1982. This primer explains the innovative financial tools that allowed lenders to lend to subprime borrowers without taking responsibility for the risk of future default. As adjustable mortgage interest rates reset, and borrowers defaulted, these tools spread that risk into every corner of the globe. This created a widespread crisis that shows no signs of ending.
Subprime borrowers are those who have poor credit histories and are therefore more likely to default. Lenders usually charge higher interest rates to provide more return for the greater risk. Normally, this makes it too expensive for many subprime borrowers to even make monthly payments.
The advent of interest-only loans helped to lower monthly payments so subprime borrowers could afford them. This increased the risk to lenders, however, because the initial rates usually reset after 1, 3 or 5 years. However, the rising housing market of the last few years comforted lenders, who assumed the borrower could resell the house at the higher price rather than default.
Mortgage-backed securities allow lenders to bundle loans into a package and resell them. In the days of conventional loans, this allowed banks to have more funds to lend. With the advent of interest-only loans, this also transferred the risk of the lender defaulting when interest rates reset. However, as long as the housing market continued to rise, the risk was small.
In fact, the advent of interest-only loans combined with mortgage-backed securities added so much liquidity in the market that it created a housing boom.
Every boom has its bust, and by 2006 the housing market started to decline. When subprime borrowers couldn't sell their houses at a higher price, they were forced to default. Since the loans had repackaged and sold, they couldn't even negotiate a settlement with their bank.
Hedge funds are unregulated and are under tremendous pressure to surpass the stock market. By March of 2007, it became apparent that they had bought a lot of subprime mortgages that were now defaulting. This caused a correction in the stock market. However, at that time, analysts proclaimed that the damage was restricted to real estate.
What made matters even worse was that many lenders spent millions of dollars to lobby state legislatures to relax laws that could have protected borrowers from taking on mortgages they really couldn't afford.
However, the risk was not just confined to mortgages. All kinds of debt was repackaged and resold as Collateralized Debt Obligations (CDO's). As housing prices declined, many homeowners who had been using their homes as ATM machines found they could no longer support their lifestyle. Defaults on all kinds of debt started to slowly creep up. Holders of CDO's included not only lenders and hedge funds, but also corporations, pension funds and mutual funds - and the individual investors who owned them.
The real problem with CDO's was that they were so complicated and so new that buyers did not know how to price them. The stock market was booming, and everyone was under so much pressure to make money that they often bought these products based on nothing more than word of mouth.
Many of the purchasers of CDO's were banks. As defaults started to mount, banks were unable to sell these CDO's, and so had less more money to lend. Those that who had funds did not want to lend to banks that might default. By the end of 2007, the Fed had to step in as a lender of last resort. The crisis had come full circle. Instead of lending too freely, banks lent too little, which caused the housing market to decline further.
