The Subprime Mortgage Crisis

What is a Subprime Mortgage?

Prime mortgages are named after the borrowers who are eligible for the mortgage. If the prime rate mortgage is offered to people with good credit ratings and long-standing credibility, subprime is for people who are struggling to meet those criteria. People who are approved of subprime mortgages historically have low credit scores and problems with debt.

People with bad credit histories like this often have tremendous difficulty getting approval on a mortgage. As such, the monthly payments have much higher interest rates than normal since the lenders view the loan as much riskier.

Sowing the seeds of the crisis

The seeds of the financial crisis were planted during years of rock-bottom interest rates and loose lending standards that fuelled a housing price bubble in the U.S. and elsewhere. And also, after the bursting of the dot-com bubble the stock market was down investors thought The US housing market was a low-risk investment so they started throwing their money into it.

It began, as usual, with good intentions. Faced with the bursting of the dot-com bubble, a series of corporate accounting scandals, and the September 11 terrorist attacks, the Federal Reserve lowered the Federal fund rate from 6.5% in May 2001 to 1% in June 2003, the aim was to boost the economy by making money available to businesses and consumers at bargain rates.

The result was now people thought to take advantage of this green signal to fulfil their dream of having their own house through low mortgage rates which led to an upward spiral in home prices. Even subprime, those with poor or no credit history, were able to realise the dream of buying a home.

The banks who were giving out these mortgages sold those loans to Wall Street banks, which packaged them into what was billed as low-risk financial instruments such as mortgage-backed securities and collateralised debt obligation (CDOs). Credit rating agencies provided these securities with AAA ratings that stated these were safe investments but unlike the ratings, these were filled with risky loans.

Signs of trouble

Eventually, interest rates started to rise, and homeownership reached a saturation point. The Fed started raising rates in June 2004, and two years later the Federal funds rate had reached 5.25%, where it remained until August 2007.

By 2004, U.S. homeownership had peaked at 69.2%. The truth was yet to be unfolded because these subprime borrowers could not cope with the rising interest rates, so they started defaulting. This put more houses on the market for sale but there were no buyers. Supply went up which was not accompanied by an increase in demand.

This caused real hardship to many Americans. Their homes were worth less than they paid for them. They couldn't sell their houses without owing money to their lenders. The most endangered subprime borrowers were stuck with mortgages they couldn't afford in the first place.

It became apparent by August 2007 that the financial markets could not solve the subprime crisis and that the problems were reverberating well beyond the U.S. borders. The Fed had 14 meetings between 2007 to 2008 to solve the problems rather than the usual 7 to keep the economy moving

But by the winter of 2008, the US economy was in a full-blooded recession as financial institutions’ liquidity struggles continued, and stock markets all over the world were at their lowest lows since September 11, 2001

The fall of Lehman Brothers (September 2008)

By the summer of 2008, the blood was spreading across the financial sector. IndyMac Bank became one of the largest banks ever to fail in the U.S., and the country's two biggest home lenders, Fannie Mae, and Freddie Mac were seized by the U.S. government.

Yet the fall of the Wall Street bank Lehman Brothers (4th largest wall street bank in the US back then) on September 15 marked the largest bankruptcy in U.S. history, and for many became a symbol of the wreckage caused by the financial crisis.

That same month, financial markets plummeted, with the major U.S. indexes suffering some of their worst losses since September 11, 2001. The Fed, the Treasury Department, the White House, and Congress struggled to put forward an out-and-out plan to stop the bleeding and restore the economy.

Effects and aftermath of the crisis

In, 2012 the Federal Reserve Bank of St. Louis estimated that after adjusting for inflation during the financial crisis, US households' net worth fell by about $ 17 trillion, resulting in a 26% loss. In a 2018 study, the Federal Reserve Bank of San Francisco found that 10 years after the financial crisis, U.S. gross domestic product was about 7% lower than it would have been without the crisis, and each American's lifetime income fell by $ 70,000.

It was found that between 2007 and 2009, about 7.5 million jobs were lost. That's twice the unemployment rate, which was almost 10% in 2010. After the recovery began in 2009, the economy slowly created jobs, but the unemployment rate fell to 3.9% in 2018, and many of the jobs created were wage-safe and safer than lost jobs. For most Americans, recovery from the financial crisis and the Great Recession was very slow.

Millions of workers lost their jobs and faced long-term unemployment, fell into poverty after the worst of anxiety. This situation was very different from the situation of the banker who helped the crisis occur. Some of these executives lost their jobs as shareholders, and the general public saw the extent of their mismanagement, while those who resigned often did so with a luxurious reward.

Moreover, unlike previous financial scandals such as the savings and credit crunch in the 1980s and the 2001 Enron bankruptcy. Finance companies and other very wealthy Americans, American CEOs and other senior executives were not defeated. By 2010, they had largely recovered their losses, but many ordinary Americans never recovered.

Impacts of the US Financial Crisis on India

Indian authorities initially denied the impact of the US crisis on the Indian economy, but the government later had to admit the fact that the US financial crisis had some impact on the Indian economy. The US crisis that shook the world had little impact on India due to strong Indian fundamentals and diminished exposure of India's financial sector to global financial markets. Perhaps this prevented the Indian economy from being immediately disrupted. Unlike the capitalist-dominated United States, the Indian market is tightly regulated by the government.

1. Impact on the stock market

The direct impact of the US crisis was felt when Indian markets began to fall. On October 10, Rs 250,000 was wiped out in a single day. The Sensex lost 1000 points on that day. This huge withdrawal was mainly by the foreign institutional investors (FII)

2. Impact on India’s export

Indian economy is highly integrated with the US economy, so the effects of the financial crisis were felt on India’s export. Manufacturing sectors like leather, textile, gems, and jewellery were hit hard because of the decrease in demand in the US and Europe. Further, as India enjoyed a trade surplus with the USA, about 15 per cent of its total export in 2006-07 was directed toward the USA. Indian exports fell by 9.9 per cent in November 2008. Official statistics released on the first day of the New Year showed that exports had dropped to $1.5 billion in November this fiscal year, from $12.7 billion a year ago, while imports grew by $6.1billion to $21.5 billion.

3. Impact on India’s handloom, jewellery

Again, the reduction in demand in the Organisation for economic cooperation and development (OECD) countries affected the Indian gems and jewellery industry, handloom, and tourism sectors. Around 50,000 artisans employed in the jewellery industry lost their jobs because of the global economic meltdown. Further, the crisis had affected the Rs. 3000 crores handloom industry and volume of handloom exports dropped by 4.6 per cent in 2007-08, creating widespread unemployment in this sector.

Conclusion

In a nutshell, it was the greed for making more money that led to the collapse of the economy. Wall Street banks were taking billions of dollars to buy mortgages to sell them as collateralised debt obligations (CDOs).

While commercial banks were giving out mortgages to people having poor credit histories to meet the demands of the investment banks, credit rating agencies were giving these financial instruments AAA ratings. Investors were so engrossed in their desire to make more money than they didn’t even care whether these instruments were even secure.

So, what’s your take, can such an upsurge of human emotions like greed and fear lead to another financial crisis? If so, what can we do to keep human emotions in check so that we don’t face the same situation again?