Subprime Mortgage Crisis

Money rules the world we live in. Be it salaries, taxes, or prices, citizens all around the world are constantly focused on the green. It has become such a driving factor in the society we live.

Money, however, can have a dark side. It can make people do things. It can be unethical, corrupt, slimy, and shady. In the course of this blog, I’d like to explore the ethics of money. There a plethora of topics which can be analyzed through this lens, and I will do my best to select germane and interesting ones.

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While I muddled through the end of elementary school around 2007, the world seemed fine to me. I didn’t have any major complaints (yet) about the world I lived in. Needless to say, my ignorance to the financial crisis that shook the American and international economy starting in 2007 truly was bliss.

In 2007, the subprime lending bubble collapsed. Leading up to this time, many borrowers were now suddenly able to get loans to finance primarily home payments for mortgages far beyond their means.

Courtesy of Investopedia

Representatives of the major banks and loaning institutions were getting filthy rich from the homes their clients were buying, so the developed a lax – incredibly too lax – policy of checking client’s chances to default on the mortgage. Known as NINJA loans, a play on the abbreviation NINA for no income no assets, these loans were risky to begin with. As the market continued to grow, these shaky investments became the bedrock on which certain economic facets laid.

First, let’s start with causes and potential culprits of the crash. Lenders are most often cited as the chief perpetrator. It is these mortgage writers that actually lent the money in the subprime loans – dubbed subprime in reference to the poor credit of the borrowers. Following the dotcom bust in the early 2000’s, banks were striving to stimulate growth by lowering rates, further pushing investors to increase their risk tolerance and lenders to seek out riskier loans.

However, the blame cannot be totally levied on the corporate finance side of the issue. Homebuyers themselves, too, are very responsible for the financial meltdown. These buyers were utilizing nontraditional mortgage techniques to purchase homes that far exceeded their incomes. When the bubble began to pop due to a variety of economic factors, buyers’ equity disappeared as home prices fell.

There is a third significant player in all of this mess. Investment banks began implementing a unique new financial instrument: Mortgage Backed Securities, or MBS’s. These investments allowed further trading of the debt held in mortgages, thereby freeing up more capital and liquidity, thereby refueling the bubble to grow even larger as the market loosened up. These MBS’s were also known frequently as Collateralized Debt Obligations, or CDO’s, named for the debt that the investors were trading.

Courtesy of Investopedia

CDO’s are a complicated beast, as I learned from the phenomenal film The Big Short, which I encourage all of you to see. Simply put, CDO’s are a type of MBS in which there a series of tranches. Each tranche corresponds to a different rating of the underlying mortgages or other derivatives. The upper tranches are safe, stable, AAA ranked instruments. Lower tranches contain the junk investments. As 2007 neared, CDO’s were becoming much more skewed towards the bottom tranches, even though the presence of only a few AAA securities in the upper tranches kept the rating pristine.

Rating agencies can be to blame for some of this conflict. Whether they were simply inept or acting for corporate gain in the form of fees from banks is unclear. However, it is reasonable to assume that proper ratings would have discouraged some investors from taking on the risk that they did by buying CDO’s, possibly easing the crash.

If it’s not clear yet, the economy of the time was a turbulent one that resulted in a crippling burst domestically and internationally.

As a result of the crash, Lehman Brothers basically went extinct. Two other enterprises, Fannie Mae and Freddie Mac, were seized by the federal government. In response to the burst, it became vastly more difficult to get housing loans, further deepening the recession that followed and prolonging the path to recovery.

The Federal Reserve stepped in and backed themselves up against the zero bound, forcing interest rates as low as possible (the eponymous 0) in an attempt stimulate economic activity. The foreclosure dilemma has persisted along with soaring unemployment and difficulty getting loans.

The boom and bust of the subprime loan industry was catastrophic for the global economy. However, it was indeed telling. Many sources have looked in to preventing such catastrophes in the future, such as the FDIC. Hopefully, such a crash can be prevented next time through clear foresight.