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Mortgage Credit Crisis
Mortgage Credit Crisis
Mortgage Credit Crisis
In the early and mid-2000s, high-risk mortgages became available from lenders who funded
mortgages by repackaging them into pools that were sold to investors. New financial products
were used to apportion these risks, with private-label mortgage-backed securities (PMBS)
providing most of the funding of subprime mortgages. 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. This enabled
more first-time homebuyers to obtain mortgages and homeownership rose.
The resulting demand bid up house prices, more so in areas where housing was in tight supply.
This induced expectations of still more house price gains, further increasing housing demand and
prices. Investors purchasing PMBS 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 homes at a gain and paid off their mortgages, or borrowed more against higher market prices.
Because such periods of rising home prices and expanded mortgage availability were relatively
unprecedented, and new mortgage products’ longer-run sustainability was untested, the riskiness
of PMBS may not have been well-understood. On a practical level, risk was “off the radar screen”
because many gauges of mortgage loan quality available at the time were based on prime, rather
than new, mortgage products.
When house prices peaked, mortgage refinancing and selling homes became less viable means of
settling mortgage debt and mortgage loss rates began rising for lenders and investors. In April
2007, New Century Financial Corp., a leading subprime mortgage lender, filed for bankruptcy.
Shortly thereafter, large numbers of PMBS and PMBS-backed securities were downgraded to high
risk, and several subprime lenders closed. Because the bond funding of subprime mortgages
collapsed, lenders stopped making subprime and other nonprime risky mortgages. This lowered
the demand for housing, leading to sliding house prices that fueled expectations of still more
declines, further reducing the demand for homes. Prices fell so much that it became hard for
troubled borrowers to sell their homes to fully pay off their mortgages, even if they had provided
a sizable down payment.
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Who was really responsible for the financial crisis?
Anytime something bad happens, it doesn't take long before blame starts to be assigned. In the
instance of subprime mortgage woes, there is no single entity or individual to point the finger at.
Instead, this mess is a collective creation of the followings:
Homeowners
Lenders
Credit rating agencies
Underwriters and investors
This situation was compounded by the September 11 terrorist attacks that followed in 2001. In
response, central banks around the world tried to stimulate the economy. They created capital
liquidity through a reduction in interest rates.
In turn, investors sought higher returns through riskier investments. Lenders took on greater risks
too, and approved subprime mortgage loans to borrowers with poor credit. Consumer demand
drove the housing bubble to all-time highs in the summer of 2005, which ultimately collapsed in
August of 2006.
The end result of these key events was increased foreclosure activity, large lenders and hedge
funds declaring bankruptcy, and fears regarding further decreases in economic growth and
consumer spending.
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Partner in Crime: Homebuyers
We should also mention the home buyers. Many were playing an extremely risky game by buying
houses they could barely afford. They were able to make these purchases with non-traditional
mortgages (such as 2/28 and interest-only mortgages) that offered low introductory rates and
minimal initial costs such as "no down payment". Their hope lay in price appreciation, which
would have allowed them to refinance at lower rates and take the equity out of the home for use in
other spending. However, instead of continued appreciation, the housing bubble burst, and prices
dropped rapidly.
A lot of the demand for these mortgages came from the creation of assets that pooled mortgages
together into a security, such as a collateralized debt obligation (CDO). In this process, investment
banks would buy the mortgages from lenders and securitize these mortgages into bonds, which
were sold to investors through CDOs.
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Systemic Risk Due to the Credit Crisis
The impact of the credit crisis extends far beyond the homeowners who lost their homes and the
financial institutions that lost money on their mortgage investments. Mortgage insurers that
provided insurance to homeowners incurred large expenses from many foreclosures because the
property collateral was worth less than the amount owed on the mortgage. In this way, the problems
of the mortgage sector affected the insurance industry. In addition, some insurance companies that
sold credit default swaps on mortgages suffered heavy losses. As mortgages defaulted, the
valuations of mortgage-backed securities (MBS) weakened. Consequently, financial institutions
were no longer able to use MBS as collateral when borrowing funds from lenders. The lenders
could not trust that the MBS would constitute adequate collateral if the financial institutions that
borrowed funds were unable to repay their loans. As a result, some financial institutions (such as
Bear Stearns) with large investments in MBS were no longer able to access sufficient funds to
support their operations during the credit crisis.
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Government Programs
The Housing and Economic Recovery Act of 2008 was passed in July 2008. The act enabled some
homeowners to keep their existing homes and therefore reduced the excess supply of homes for
sale in the market. The financial institutions must be willing to create a new mortgage that is no
more than 90 percent of the present appraised home value. Other programs promoted “short sale”
transactions in which the lender allows homeowners to sell the home for less than what is owed
on the existing mortgage. The lender appraises the home and informs the homeowner of the price
it is willing to accept on the home.
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