Subprime mortgage crisis

The subprime mortgage crisis was a financial shock that originated from defaults on the United States mortgage markets, and caused serious financial problems among the providers of finance to those markets, including the government-sponsored enterprises Fannie Mae and Fannie Mac and several major banks. As explained by Nobel Prize-winning economist Paul Krugman:

The bursting of the housing bubble has led to large losses for anyone who bought assets backed by mortgage payments; these losses have left many financial institutions with too much debt and too little capital to provide the credit the economy needs; troubled financial institutions have tried to meet their debts and increase their capital by selling assets, but this has driven asset prices down, reducing their capital even further.

. The crisis subsequently spread to other financial markets to lead to the global Crash of 2008.

(for definitions of terms shown in italics, see the glossary on the Related Articles subpage and for the sequence of events connected with the crisis, see the Timelines subpage).

The Crisis

A period of low interest rates in the early years of the century, combined with the ready availability of credit and a general belief that house prices would continue to rise, led mortgage lenders in the United States to approve loans without taking prudent account of borrowers' ability to pay, and led borrowers to take out larger loans than they could afford. Optimism about prices also led to a boom in house-building. In 2007, following subsequent interest rate increases, there was a sharp fall in house prices, making many owners of mortgaged houses unable to use them as security for further loans, leaving many of them with payments that they could not afford, and leading to a marked increase in mortgage defaults.

That led to serious financial problems at the government-sponsored enterprises Fannie Mae and Freddie Mac (the major providers of finance to the United States mortgage markets) and at those banks who were also important sources of its finance. An atmosphere of general uncertainty about the value of some mortgage-backed assets developed among other providers of finance to those markets. Operators in the financial markets became reluctant to lend money on the security of those assets, placing other holders of those assets in financial difficulties. There developed a loss of confidence in organisations that were suspected of being vulnerable to the falling value of their holdings of all mortgage-related assets, and in March 2008 Bear Stearns, (another major US investment bank) was rescued from bankruptcy following losses relatied to mortgage-related assets held by its hedge fund subsidiaries. By the middle of 2008, US house prices had fallen to 20 per cent below their 2006 peak, there was a further increase in defaults. Then, in September, Fannie Mae and Freddie Mac suffered a financial collapse and were nationalised, and Lehman Brothers (another major US bank) declared itself bankrupt, and a general shortage of credit was developing. By that time the crisis had spread beyond the United States and many banks in other industialised countries, that were holding assets based upon US mortgages, had failed or were in financial difficulties.

Among the factors that are considered to have contributed to the development of what is considered to have been the house price "bubble", and to the problems that arose from its collapse, are the conduct of monetary policy, the inflow of funds from abroad, Government housing policies, the creation of new ways of financing mortgages, the conduct of providers of mortgage finance; and the consequent behaviour of the housing markets.

Monetary policy

There is some evidence of a connection between the subprime crisis and the Federal Reserve Bank's conduct of monetary policy. Since the 1980s, the Bank's monetary policy had successfully stabilised the American economy - and its housing market - by the application of the "Taylor Rule" under which changes to the bank's discount rate had been related to the spare capacity in the economy. During the period from 2003 to 2006, however, the discount rate was held well below the level suggested by that rule. The author of the rule, Professor John Taylor of Stanford University, has given an account of the consequences of that departure . He argues that those low interest rates helped to foster the extraordinary surge which occurred in the demand for housing, and that the eventual fall in housing prices would have been less steep, and the following crisis less severe, had the Taylor rule been followed.

The "wall of money"

A connection has also been noted between the housing boom and increases in the availability of finance. However, the funds used to finance the surge in housing investment were obtained largely by borrowing from abroad, rather than from domestic savings . In the early years of the 21st century there were large inflows of money from abroad, corresponding to the country's large current account deficit . That development was attributed by some commentators to increases in the federal budget deficit, but Federal Reserve Bank Chairman Ben Bernanke argued that it was caused mainly by a "savings glut" in China and other developing countries resulting in large purchases of American securities (sometimes referred to as "the wall of money"). A correlation between the growing current account deficit and increases in housing investment had also been noted by the Board's previous Chairman .

Housing legislation

Another influence upon the housing market was the Community Reinvestment Act 1977 (CRA), which required the Federal Reserve Bank and other government agencies to encourage banks to provide credit to low-income families ""in ways that are consistent with safe and sound banking operations".. The Act does not provide for grants to individuals, but encourages regulatory authorities to make their authorisations, in response to applications by mortgage-lenders, conditional upon their performance in meeting the aims of the legislation. Since its inauguration, it has been strengthened by a succession of amending enactments, , and in 2008 there were reports that it was inducing mortgage-lenders to take greater risks than they had been accustomed to. For example, pressure to conform was reported to have influenced the government-sponsored enterprise known as "Fannie Mae" to undertake more risky investments .

Securitisation

A further contribution to the crisis arose from changes in the late 20th century in the way that mortgages are financed. Banks had previously financed their lending mainly by deposits from their customers. That practice was largely replaced by the practice of converting mortgages into graded securities and selling them on the bond markets - a practice that made possible a massive increase in mortgage lending, . Bank mortgages came to account for a substantial proportion of a market that had previously been dominated by the government-sponsored agencies (Fannie Mae and Freddie Mac) , and mortgage-related bonds came to occupy an important place in the bond market .

Lending policies

Other important factors were the easing of credit terms for loans to low-income borrowers by the government-sponsored enterprises (Fannie Mae and Freddie Mac) , and the growing proportion of loans that went to "subprime borrowers" . Subprime borrowers were people who had been given low credit ratings because they had a history of late payments or defaults. Subprime mortgages were much more profitable than normal mortgages because, compared with a typical 5 percent interest rate, subprime borrowers were usually charged about 7 percent. Often they were sold to existing home owners who needed money to pay off other debts . Some were sold by mortgage brokers who adopted "predatory lending " practices, or otherwise misled their clients, . Most of them were "adjustable-rate mortgages" with initially low repayment rates that were due to be raised after the first two or three years.

Housing market developments

In response to the surge in the demand for housing in the period 2003 to 2006, the annual rate of growth of house prices rose to ten percent in the fourth quarter of 2004 and continued at that average rate for two years, reaching twenty percent at times. Expectations of price increases further accelerated the demand for housing, putting further upward pressure on prices. With the consequent development of a major "housing bubble" ,, there was a fall in the number of defaults and foreclosures of subprime mortgages, leading to increases in the credit ratings of mortgage-backed securities. Those increases turned out to be transitory, however. When interest rates returned to more normal levels in 2007, the demand for housing fell sharply, house prices fell, and there was a surge in defaults by subprime mortgage holders, many of whom then found themselves unable to use their houses as security for further borrowing.

Financial stresses

The surge in defaults in the subprime mortgages market led credit agencies to downgrade their ratings of securities based upon those mortgages, and banks holding such securities found themselves unable to use them as collateral for their borrowing needs. This created financial problems that started with Fannie Mae and Freddie Mac and then shifted to the major banks . Hedge funds guaranteed by the American Bear Stearns bank ran into difficulties as a result of the downgrading, and the bank had to be rescued. Downgrading of their assets led subsequently to the collapse and government rescue of Fannie Mae and Freddie Mac. Uncertainty about the quality of banking assets made banks reluctant to lend to each other and the important interbank market ceased to operate. Banks that had relied upon that source of finance, such as the UK's Northern Rock also ran into difficulties leading to a further loss of confidence. Following severe losses as a result of the subsequent Lehman Brothers bankruptcy, the short-term money market also ceased to operate.

Crisis

The loss of investors' confidence in their assets, combined with the closure of what had been their major sources of short-term borrowing, put banks and other financial institutions throughout the world in severe financial difficulties, leading to the crisis described in the article on the crash of 2008.