Subprime mortgage crisis

The subprime mortgages crisis was a financial shock that originated from defaults on the United States mortgage markets, and spread to other financial markets to lead to the global Crash of 2008.

For definitions of the terms used in connection with the crisis in this article, please see the glossary.

For the sequence of events connected with the crisis, see the timelines subpage.

The Crisis

Unexpected defaults by the holders of some mortgages led to general uncertainty about the value of mortgage-backed securities. Operators in the financial markets became reluctant to lend money on the security of such assets, placing holders of those securities in difficulties. There developed a loss of confidence in organisations that were suspected of being vulnerable to the falling value of their holdings of mortgage-related securities, and that created a widespread financial crisis.

Among the factors that are considered to have contributed to the development of the crisis are the conduct of monetary policy, the inflow of funds from abroad, the creation of new ways of financing mortgages, the policies adopted by 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 deficit and increases in housing investment had also been noted by the Board's previous Chairman .

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

An important factor was the growing proportion of mortgages, financed by the government-sponsored agencies as well as by the banks, 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 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, and there was a marked increase in defaults by subprime mortgage holders.

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. 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. 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.