There are several factors that have caused the current economic crisis. At its very core, the sub-prime mortgage crisis was the catalyst.
To give you a brief history of how the sub-prime mortgage crisis began, let’s first explore what a sub-prime mortgage is. It is an adjustable rate loan that was offered to individuals who had bad credit. The brokers who engaged in offering these mortgages received commissions on every sale, and thus the need to entice and cajole buyers into purchasing homes (whether they could afford them or not) was the basis of their sales pitch.
During the housing boom, these predatory lenders sold homes to individuals without checking their FICO scores and subsequently offered homebuyers interest rates that were so low that they were, in one word, “irresistible”.
Unbeknownst to the buyers, however, within a short period of time the interest rates increased and some homeowners were forced to apply for equity loans as a result. However, what transpired thereafter was that the lenders then sold the mortgages to investors here and abroad. As a result, the interest rates on the mortgages increased to a point that the homeowners could not meet the mortgage payments. Foreclosures then ensued, prices of existing homes declined, and the housing market virtually collapsed.
According to foreclosuredataonline.com, the serious sub-prime mortgage crisis began in June of 2007 when two Bear Stearns hedge funds collapsed. This had a rapid effect on other parts of the financial markets worldwide, which reached the crisis level in August-September of this year and temporarily froze the money market sector that is critically important to banking and financial operations.
As sub-prime mortgages began to reset in droves and result in foreclosures, housing prices also declined. Because of the way these loans and CDOs (Collateralized Debt Obligations) were globally distributed, it knocked the whole system out of whack. Keep in mind that a single CDO package might contain as many as 100 sub-prime mortgage loans. As the defaults continued, the worldwide CDOs took a major hit and the entire thing went down like a house of cards.
Paul Krugman, economist and Nobel Prize winner noted that the innovations of recent years — the alphabet soup of CDOs and SIVs (Structured Investment Vehicle), RMBS (Residential Mortgage-Backed Security), and ABCP (Asset-Backed Commercial Paper) were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn’t have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized.
Why was this allowed to happen? At a deep level, I believe that the problem was ideological: policy makers, committed to the view that the market is always right, simply ignored the warning signs. The bottom line is that policy makers left the financial industry free to innovate — and what it did was to innovate itself, and the rest of us, into a big, nasty mess.
