You may have heard the old Chinese curse: May you live in interesting times.
Do we ever. History is in the making, and what a story it is. Since the second half of 2007, the worldwide financial system has been steadily unraveling. Most of the world’s major economies have entered recession, and we’ve yet to see any sign that things are getting back on track.
About 40 banks, a major insurance company, two government-sponsored housing lenders (Fannie Mae and Freddie Mac), and numerous investment banks are teetering on the brink of collapse, propped up only by a huge infusion of taxpayer bailout money. Each day brings more reports of layoffs, the housing market remains in a funk, and consumers are showing increasing signs of financial distress.
So how exactly did we get here? The credit crisis is like the proverbial flapping of a butterfly’s wing: A seemingly insignificant series of events that create huge repercussions around the entire globe.
Act I opened innocently enough in a small segment of the housing sector: the subprime lending market. In the heyday of the decades-long housing boom, mortgage lending was a very profitable business. Lenders were so eager to give out loans that they gradually began to loosen lending standards and increase the number of subprime loans, approving people who wouldn’t normally qualify for loans.
Subprime lending was great for business. The mortgage rates charged on subprime loans were, on average, about 2% higher than normal, giving lenders a handsome profit on their loans. And while these loans were more risky, they were secured by the house backing the mortgage. Housing prices had been on a steep incline from the early 1990s, so even if a subprime borrower had difficulty meeting mortgage payments, the steady increase in home values would enable him or her to refinance or even sell the house instead of defaulting on the loan.
The most common type of mortgage given to subprime borrowers was the so-called adjustable rate mortgages, or ARMs, i.e., loans in which the interest rate is adjusted after as little as two to three years. ARMs come with lower initial interest rates, and this in turn enabled people to take out high mortgages and still have a very low monthly payment.
This was ideal for subprime borrowers, who were unable to afford a high monthly mortgage. No surprise, about 80 percent of subprime borrowers received ARM loans or a hybrid of these. Between 2000 and 2006, subprime mortgage loans more than tripled.
Then, in 2004 interest rates began to increase. At the same time, housing prices, which had been on a precipitous rise for almost two decades peaked and eventually began to decline.
Subprime borrowers, who were at the marginal end of the mortgage market, felt the impact first. Suddenly, when the interest rate on their ARM loan adjusted upward, it was no longer possible to turn around and refinance the loan at a low interest rate. However, when the interest rate on their mortgage increased, so did their monthly payment. Because subprime borrowers were financially strapped to begin with, many were unable to meet the increased mortgage obligations. Eventually many were forced to default on their loan.
Subprime borrowers were not the only ones taking a hit, however. Many borrowers with good credit had relied on the availability of inexpensive credit and the increasing home values to take out high-risk loans. They too suddenly found that the music had stopped playing, and there was no chair to sit on.
The result was a classical vicious economic cycle: higher rates of delinquencies and foreclosures in the housing sector caused lenders to tighten lending standards and give our fewer loans. With more houses on the market and fewer buyers, housing prices began to go down. With lower housing prices, home owners who needed to refinance found that they were unable to do so, because there was no longer enough equity in their home for the loan. This in turn caused more loan defaults and foreclosures, leading to more houses on the market, which led to lower housing prices. And on and on.
The subprime lending crisis was the first flapping of the butterfly’s wings. It was a series of events, which under normal circumstances should have caused only a short-term financial blip. Yet, as we shall see in Act II, the subprime mortgage crisis contained within it the seeds of a much larger problem, which to this day, threatens to unravel the worldwide financial system.
