If you ask anyone what the biggest trigger of the crisis was, they are likely to tell you “the irresponsible lending of subprime mortgages”. Subprime mortgages are mortgages where the borrower has low income relative to the size of the loan and possesses few assets other than the house being bought. So essentially, the likelihood of the loan not being repaid is higher than normal.
But how, you may ask, could a bunch of shitty mortgages bring down the whole financial system? Well, the answer is that there weren’t few, but millions. Also, these subprime mortgages were everywhere, quietly brewing in all sectors and corners of the global economy, meaning that when the US housing bubble burst, the whole financial world imploded with it. But again, we’ll get back to that later.
Ok, lets pause and go back a second. It is in fact necessary to understand why this toxic lending trend existed in the first place. In order to do this, we need to look at the former economic climate.
The years before the crisis, saw an unprecedented level of debt-build up in the United States, particularly in the household market where ordinary people and families started to become dangerously overleveraged. This happened because back in 2006, in the US, short-term interest rates were lower than long-term interest rates. As the name suggests, the difference between the two lays in their repayment schedule; short-term loans are repaid quicker (usually within a year) whilst long-term loans run their course over a longer period of time. As a result, lenders view short-term loans as less risky than long term loans, as the former enables them to be repaid quicker. The interest placed on each of these loans thus reflects this risk-reward scenario; short-term loans have lower interest rates whereas long-term loans have higher interest rates as lenders have to bear the risk of their longer-term investment.
This meant banks were borrowing short-term in order to lend long-term and reap the profits from this opportunity, and one particularly lucrative long-term loan they focussed on were mortgages.
This opportunity came at the same time of the housing boom, which started in 2002-2003 as home construction was rapidly increasing in the US. As a result, speculation in the housing market ensued. This meant that as prices rose, people bought more houses (both because the lending terms were favourable and because they might have also had the intention of selling it a higher price somewhere down the line). This trend was more than welcomed by the banks who, as mentioned above, wanted to benefit from the higher interest rates on long-term loans and gave out a lot of mortgages, even to people with questionable finances (but again, we’ll get back to this later).
As a result, from 2001-2007 the mortgage debt level per household rose 63% faster than household incomes (essentially meaning that people were borrowing money at a way faster rate than they were earning it). Liquidity seemed limitless and asset values (in this case house prices) seemed destined to keep rising, so banks just kept on giving out mortgages. It is in this manner that bubbles start forming.
Just like gambling and the adrenaline rush that comes with it when you’re on a winning streak; it becomes impossible to just walk away. This is the psychological explanation at the heart of this lending and borrowing mania which permeated the mortgage market.
But how did it all get so bad?