Explained: The Build Up, Causes, And Effects Of The US Subprime Crisis

Introduction: 2007-08 US Subprime Crisis

The 2007-08 US subprime crisis occurred as a result of the public policy partnership by the US government to enable financing techniques (mortgages) to provide affordable housing to marginalised people of the society. The crisis evolved as mortgages-backed securities – a financial technique – was fueled by the encouragement of the government regulators for the growth of such techniques.

There were many professionals, both government and private, involved trying to curb the effects of the bad loans, particularly known as subprime, after the fall of Lehman Brothers.

This article aims at looking into the reasons which led to the crisis, what measures were taken by the authorities considering the scenario, and what effects the crisis had worldwide.

The Onset Of The Crisis

Though it occurred in 2007, the subprime crisis started to build up from 2001. It started as a result of an increase in the subprime and to secure these subprime loans. There is a need to understand why investments were made into such a risky market, and what factors fueled and finally led to this crisis.

To understand this, we’ll take Charles Kindleberger’s model to study the crisis. His model can be used to interpret the crisis on the basis of the erstwhile crisis in the 18^th and 19^th centuries (see Evidence [1]). He gave four stages for the analysis:

1. The first stage is monetary expansion, which makes the investors more speculative in their transactions. And, as the market is expanding, the investors invest in the market although it is risky.
2. As a result, risky asset bubbles emerge which are fueled further by investors.
3. When there is a monetary restriction, people start to pull out which creates an unfavorable shock. This leads to a domino effect and resulted in deteriorating bank portfolios.
4. The crisis erupted and government intervention becomes necessary when institutions start to fail.

The evidenced book’s author D. Gyorffy also gives three reasons explaining why such risky measures are considered profitable.

• The first is the liquidity that was created in the market due to the negative real interest rates in-between 2001 and 2005, which was a contributing factor to the increasing indebtedness.
• The second reason is the huge losses incurred by the US due to the Afghanistan and Iraq war, along with the tax cuts.
• The third reason is the international monetary situation. Gyorffy said that Asian countries had accumulated large dollar reserves which greatly impacted the liquidity in the US markets.

Hence, due to these reasons, taking a risk to attain moderate returns became necessary.

There were other reasons as well for the growth of mortgage-backed securities as stated by a group of researchers, who researched that the expansion in these mortgages was a result of the entry of private-label mortgage-backed securities. Investors in search of higher returns often ended up investing in such securities, which further led to an increase in securtized share of the subprime mortgage market from 8% in 2001 to 20% in 2006, and an increase in the securitized mortgage sector from 54% in 2001 to 75% in 2006 (see Evidence [2]).

Another reason for the expansion of subprime loans can be given to Government Sponsored Enterprises (GSEs), which were formed as a result of the Leftists’ agenda of providing reasonable home loans to the marginalized of the society. GSEs were privately operated government enterprises.

The role of these GSEs was to promote reasonable mortgage lending practices among private banking systems. But, all that these GSEs were able to accomplish were investments into high-risk subprime mortgage securities, and mechanisms which would ensure returns during profit terms and ensure a safe exit for GSEs during losses (see Evidence [3]).

The standards for the lending of mortgages under these GSEs were reduced to a level where a person could buy a mortgage at zero down payments. From a 3% down payment in 1995, it reduced to 0% in 2000. The percentage of mortgages with 0% down payments was at 45% in 2006 (see Evidence [1]).

Christopher Whalen, an investment banker, and author, also blames the Securities and Exchange Commission for adopting “Fair Value Accounting,” which were faulty in its measures of deciphering the value of companies on Wall Street (see Evidence [4]).

The Downfall 

The downfall started when the two supporting pillars of the system fell. The first was the increase in real estate price and second was the liquidity in the market (see Evidence [1]). D. Gyorffy said that by 2007 these two pillars went missing. The demand for real estate decreased due to two reasons: an increase in the interest rates in 2005, and also because of the high vacancy rate, which was at 50% in 2007. This was as a result of high supply and reducing demand in the real estate sector.

The homeowners owed more than what the value was worth, hence, they gave up the houses, and this increased defaulters in the subprime. In 2008, the percentage of foreclosures reached 79%, hence, the investors panicked and the crisis came into effect. When people wanted to sell off these houses at higher prices they couldn’t do that, and even the banks foreclosed when the value of such houses became less than that of the mortgage. The banks started to lend much less than before, fueling the decrease in the housing market (see Evidence [5]).

The spread in the crisis increased as big names projected huge losses and also resulted in the closure of Lehman Brothers and huge losses by Bear Sterns (see Evidence [1]).

Effects Of The Crisis

1. 1. Effects on the economy: The largest effect of the crisis was seen by the suburb areas in the states like Michigan, Ohio, Youngstown, and some parts of Grand Rapids. Poverty rates kept increasing, due to large number of foreclosures the areas went deserted and many people lost their jobs (see Evidence [6]).The Federal Reserve estimates around 2.5 million foreclosures in 2010, unemployment rose up to 10% in 2011 and people have a hard time doing payments because of the unemployment. Estimates suggest that after the crisis in 2008, 49% of people lived on paycheck-to-paycheck compared to 45% just a year back in 2007. Also, 1.4 million people filed for bankruptcy, 32% more than in 2008 (see Evidence [6]).
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   2. Global-level effects: The global GDP of developed nations fell from 69% to 60% in the past decade (see Evidence [7]). The direct effect of the crisis was the debt the economies had to encounter. The debt in 2016 was at 106% of the GDP of the advanced economies compared to 72% in 2007.Unemployment rates even in other countries, for example, Spain (15%) and Greece (20%) remained high (see Evidence [7]). There were write-downs of the debts of the US financial companies estimated at $2 trillion and these non-performers are still written on banks’ books of many European banks. In Europe, the percentage of these pre-2008 non-performing assets are at 4% and the highest is in Italy at 17%.

Other than all these effects, there has been restructuring of financial institutions for such crisis. The central banks have been turned into shock observers and the risk levels that central banks now bear are really high (see Evidence [8]).

There were bailouts of many faulty institutions such as the Freddie Mac and the Fannie Mae, the bailouts of such institutions by the government raises a question of morality. Countries with fixed economy exchange systems suffered a lot. For example, Namibia, which encountered high unemployment rates as it had a fixed exchange rate system at the time of the crisis (see Evidence [8]).

Evidence

[1] Gyorffy, D. (2009). The Enduring Lure of Socialism: the Political Economy of the Subprime Crisis. Journal for Comparative Government and European Policy Vol. 7, No. 2, 250-275.

[2] Demyanyk, Y., & Hemert, v. (June, 2011). Understanding the Subprime Mortgage Crisis. The Review of Financial Studies Vol. 24, No. 6, The Academic Analysis of the 2008 Financial Crisis, 1848-1880.

[3] Press, D. (September 14, 2018). How the Federal Government Created the Subprime Mortgage Crisis. (Foundation for Economic Education [FEE].)

[4] Whalen, C. (2008). The Subprime Crisis—Cause, Effect, and Consequences. Journal of Affordable Housing & Community Development Law Vol. 17, No. 3, The Mortgage Crisis, 219-235.

[5] Amadeo, K. (November 20, 2019). The Causes of the Subprime Mortgage Crisis. (The Balance.)

[6] Begany, T. (June 25, 2019). 5 Consequences Of The Mortgage Crisis. (Investopedia.)

[7] Oxenford, M. (January 12, 2018). The Lasting Effects of the Financial Crisis Have Yet to Be Felt. (Chatham House, the Royal Institute of International Affairs.)

[8] Ramlall, I. (2013). The Impact of the Subprime Crisis on Global Financial Markets, Banks and International Trade: A Quest for Sustainable Policies. (Cambridge Scholars Publishing.)

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