What are the first images that come to your mind when you hear about the Global Financial Crises? Probably you would visualise people roaming around the streets unemployed, financial institutions destroyed and people in queues demanding their money back. If you have a little knowledge about this you might also see a house wrapped around in a bubble just about to fall. To put forward a further question, I ask you what caused the Financial Crises?
Articles, videos, and lectures revolved around the subject focus extensively on just one thing “Subprime Mortgages”. In this article, I focus on mentioning why are the sub-prime mortgages not bad in principle and why were they not the primary contributors of the Global Financial Crises, 2008.
Here, I would like to introduce the term Subprime Mortgages. Subprime mortgages as the name suggests is a mortgage loan which is not taken up by the prime population such as the wealthy businessmen and politicians. These are the loans taken up by the people below them in economic stature popularly known as the low-income and middle class. Technically by definition it means any person having the FICO score (a measure of consumer credit risk) below 630 is characterised as a sub-prime borrower.
Before moving forward, it is important to understand the hypothesis that we are dealing with in this article. It primarily focuses on the subprime borrowers leading to the Global Financial Crises. This works its way as these borrowers have a lesser chance of returning the money due to their financial condition and thus, they would lead to the collapse of the entire system of Mortgage Backed Securities, ultimately leading down leading to a crisis. While I won’t go into the details of the Mortgage Backed Securities; in its simplest terms it could be understood as a group of securities bundled together and then sold to the interested investors. Let us see why this hypothesis does not hold. To understand this it is important to focus on the fact that how did the US mortgage market worked. The US mortgage market offered multiple mortgage options. There was the standard 30-year fixed-rate mortgage which was the most popular at that time. But what would be of more interest to us is the other type of mortgage known as the teaser rate mortgage. This allows the borrowers to have a fixed rate of interest for a fixed time period which is usually lower than the existing market rate and after that fixed time gets finished the interest rate is pegged to some universally accepted rate of interest such as the LIBOR (London Inter-Bank Offered Rate), usually some base points over. Also, after this fixed term, the borrower gets an opportunity or option to continue with the current existing agreement or opt out of it. If it decides to opt out, the borrower has either the option of refinancing or pay a one-time fine to the bank.
One thing that had been increasingly talked in almost every explanation of the crises was that these sub-prime mortgages were bad in principle or they were ‘designed to fail’. For carefully looking at its answer we really need to think about the Financial System and the fact that would the Financial System create such an instrument deliberately which is bound to always fail. Well, the obvious answer is no; it is rather an instrument or a system which benefits not only the borrower but also the bank. Let me explain you how. These mortgages worked on a teaser rate system explained above. This means that the borrowers could get relief from some time in the beginning by lower interest rates while in the later years they have an option to adapt as per their financial conditions. This system works perfectly well for both parties but only if there is a rising housing market. Let us understand this by an example. Suppose you have a house with a 30 lakhs mortgage value and you need to pay an simple interest rate of 2% per year. By the end of 5 years, you thus pay the bank 3 lakhs in interest rates, but if the house value jumps from 30 lakhs to 35 lakhs you essentially gain 2 lakh (5 lakh – 3 lakh) rupees. So, now you have both options available in handy for you. You could obviously continue with the agreement, but also now you have enough money to even pay the bank a penalty and refinance your mortgage. What is more interesting is that these mortgages performed perfectly well within permissible limits from 2000 to 2007. Thus, we can conclude that these weren’t bad in principle.
This system failed only when the housing prices didn’t rise and the borrowers couldn’t pay their mortgages. But wasn’t this the case with almost all mortgages and almost all borrowers. While some people couldn’t pay for their mortgage there were some who just found it unfeasible to pay back, so why are the sub-prime loans separately targeted in every discussion of the Global Financial Crises. The housing market collapse spared none not even the wealthiest who found themselves defaulting. No doubt there was an upsurge of sub-prime mortgages but as witnessed in the paper of ‘The Causes of the Foreclosure Crises’ by S Geradi and Paul S Willen 2012 we find out that the number of mortgages increased in magnitude for all the kinds of loans. The housing market failure was a result of all and not just the Subprime loans which were given undue attention.
One thing that might come to your mind is that why am I protecting these mortgages? Well, I have a reason for that, after the crises ended it became increasingly difficult for a person with low income to have a house of its own. The American Dream was confined only to a selected rich class who probably contributed more to the crises. Yes, you heard that right they probably contributed more to the crises. The reasoning could be understood if you look at the Housing mortgages failure not in terms of the number of failures but in terms of values of these failures. Now let’s get some facts clear. A subprime-mortgage borrower is primarily characterised by low availability of financial stability and income. So, he has a greater chance of living in a smaller house than any of him prime counterpart. As established above, the mortgage repayment was income inelastic and when these big mansions don’t pay their mortgages the failure in terms of value is huge. In value terms every mansion could equal up to 5 or even 10 smaller houses, so is blaming the sub-prime borrowers the correct thing. I think one should think it through.
I would like to conclude by mentioning that the crises were not a result of the sub-prime mortgage lending, they were a factor surely but so was every borrower who failed to repay their mortgage. The crises essentially were a problem of hind-sightedness and people’s inability to imagine that the financial system could collapse. The last big event that shook the entire world and similar to this was in the 1930s. The event stored in the memory of none resulted in everyone playing risky. People just couldn’t imagine that house prices might move in the downward direction too.