Subprime mortgage crisis: the cause of the 2008 stock market crash - GETMONEYRICH (2023)

More than a decade has passed since the 2008 financial crisis originated in the US. Since then, several publications have pointed out the causes of the crisis. The most common cause is attributed to the 'subprime mortgage'. Subprime refers to Mortgage Backed Securities (MBS), but in a very special category. Let's read more about why I refer to it as very special.

It was "Lew Ranieri" who first coined the theory ofput to safetyMortgage-Backed Securities This eventually led to the formation of our modern mortgage-backed securities. Therefore, the first blame for the crisis must fall on him. 🇧🇷

In theory, Lew Ranieri could be guilty. But in practice there was a series of mistakes, ignorance and bad practices that ended up leading to the global crisis.

In this article, we will attempt to discuss the chain of activities that gave rise to subprime mortgages, which in turn triggered the 2008 financial crisis.

Let me explain the events sequentially.

Themes

• Subprime mortgages.
  • 1. About a mortgage.
  • 2. Participation of Investment Banks.
  • 3. Mortgage Backed Collateral (MBS) Requirement.
  • 4. How did investment banks make money?
  • 5. How did MBS investors make money?
  • 6. MBS overdemand.
  • 7. Collateralized Debt Obligations (CDOs).
  • 8. Rising real estate market.
  • 9. Role of other agencies (credit assessment, insurance).
  • 10. Why do people take out loans?
  • 11. The housing bubble burst.
  • 12. More bad loans.
  • 13. What the big investors did...
  • 14. The recession has arrived.

subprime mortgages

To understand what a subprime mortgage is, it is essential to know the blueprint of how the mortgage business operates in the US. Once we are clear about this flow, we can identify and understand the root cause of the crisis.

A subprime mortgage is the main cause. But it is also important to appreciate the ripple effect caused by the subprime mortgage, which eventually led to the financial crisis of 2008.

Here are some terms (concepts) briefly explained that you need to remember to understand the enormity of subprime mortgages.

The terms

• Mortgage: It is a loan taken out at a bank to buy a house. It's an agreement between homebuyers and banks. The homebuyer agrees to repay the bank over time. The refund will be the principal amount plus interest. Until that time, the 'house' remains the borrower's pledge.
• banks: There are two types of banks involved. First, there are retail banks that lend money to borrowers. The second type is investment banks to which retail banks eventually sell loans. Let's read more about it in this article.
• Captivity: These are risk-free fixed income investment options. They can generate very predictable returns. Why? Because they are backed by the US Treasury Department. But on the downside, its returns are low. Some examples of this are treasury bonds, etc.
• Mortgage Backed Security (MBS): These are like bonuses. Its shares are also traded on the secondary market. But the only difference is that they have a higher risk of loss (compared to government bonds). Therefore, to offset this risk, they offer higher returns.
  • What is MBS?: All mortgages purchased by investment banks are pooled and an MBS is formed. What is MBS? It is a financial instrument whose assets areloan contracts. Why is it called an asset? Because loans generate income in the form of monthly payments, which borrowers regularly pay to the bank..
  • MBS types: The way mortgages are contracted gives rise to different types of MBS. For example, one type of MBS will include those mortgages whose borrower profile has a credit score greater than 720 (preferred borrowers). Another MBS can be formed whose credit profile is below 700.
  • Investment in MBS: MBS shares are traded on the secondary market. Interested persons can buy and sell MBS shares (like shares). There will be some investors who will only buy MBS>720. There will be some investors willing to take more risks and even buy MBS <700. Why? Because in normal times, riskier investments can yield higher returns.

• subprime mortgages: Mortgage-backed securities where the borrower's risk profile is very low (eg, MBS < 650) are classified as subprime mortgages.

• loan for all: In an MBS-backed mortgage market, anyone can get a loan. Suppose there is an MBS whose borrower risk profile is below 650. In traditional banking, people with a score below 650 will not be able to get a loan. But in the MBS market, even such people can get a loan, until the shares of that MBS have buyers on Wall Street.

Now that we know these concepts, we are ready to hear the story about the cause of the financial crisis of 2008. This story will explain in simple language the sequence of reasons that led the American economy to the financial crisis of 2008.

1. About mortgages

People looking to buy homes go to retail banks and apply for a loan. The loan application is completed and sent to the bank.

These banks, in turn, verify the borrower's credentials. If the borrower meets the minimum criteria, the loan will be issued.

Someone who has a stable job/business, high income and good credit score (like above FICO 720) will get a loan easily and at a lower interest rate compared to others.

People with lower FICO scores may not be able to get a loan. They can also get a loan but for them the criteria will be strict like higher down payment, higher interest rates, shorter loan duration etc.

But here too the banks will have a minimum criterion. If a person does not meet these criteria, then he can forget about the loan.

2. Participation of Investment Banks

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In traditional banking, there are only two branches that deal with loans: borrower and lender (home buyer and retail bank). But in the 2000s, a third party got involved: investment banks.

These investment banks began to buy the "mortgage contracts" of retail banks. In this way, they were entitled to receive the monthly payments from the borrowers.

The role of retail banks has been substantially sidelined. Its responsibility was limited exclusively to issuing loans. After this stage, its function was to sell the loans to investment banks. Time course.

From then on, investment banks became the holders of mortgage contracts.

Why did retail banks sell the loans? Because this way, your balance sheet had zero liabilities and only cash assets (received from the investment bank).

Why did investment banks buy loans? For use as Mortgage Backed Securities (MBS).

3. Need for Mortgage Backed Securities (MBS)

In the 2000s, the yield on government-backed securities (such as Treasuries) was very low. All of the risk-free fixed-income instruments were generating very low returns. So bankers were busy inventing a low risk, alta performanceinvestment option. This gave rise to mortgage-backed securities (MBS).

Since MBS had "mortgage loans" as assets, it was considered safe. At a time when Treasuries yielded less than a 3.5% return, the MBS could promise a fixed return of 5-6%.

4. How did investment banks make money?

Investment banks bought loans from retail banks. Several of these mortgages wereclubed togetherto form a mortgage-backed security (MBS). This MBS was valued based on itsfuture earning potential.

What is the future revenue of MBS? Monthly payments are received from homebuyers.

Suppose there is an MBS whose net worth is $1 billion. This MBS is divided into billions of equal parts. This means that each MBS share has a value of $1 (net worth / number of shares). These MBS shares are now traded on the secondary market (Wall Street).

Assume that each share of MBS sells for an average price of $1.2. In other words, MBS could generate funds of $1.2 billion ($1.2 billion x 1 billion shares).

The investment bank paid a total of $1 billion to buy mortgages from retail banks. With the issuance of shares, they earned US$ 1.2 billion. The investment bank's gross profit is $0.2 billion.

5. How did MBS investors make money?

Suppose there is an MBS that was worth a billion dollars. He managed to earn $57.2 million a year for the next 30 years.

Where did that income come from? Sincemonthly paymentsmade by borrowers to pay their mortgages.

These monthly payments received by the investment bank (MBS) will be distributed proportionally among the investors inproportionate to your actions🇧🇷 If there are 1 billion number shares, the earnings per share of that MBS is $0.0572.

• What will the return per share be for investors?
  • Share price: $1.2 per share.
  • Income: $0.0572.
  • Yield: 4.77% (0.0572/1.2).

This means that when buying an MBS share, the investor will have a return of 4.77% on his investment.

6. MBS overdemand

Until loans were extended to reliable borrowers, the market for mortgage-backed securities exploded. It was a perfect investment vehicle for mature economies (like US, UK, Australia, etc.). Demand for MBS skyrocketed.

To feed the growing demand, MBS needed more mortgages. But the problem is that borrowers in the United States are limited.

In this scenario, retail banks have changed their criteria for granting credit. They even started issuing loansnot so reliable borrowers.

But they charged higher interest rates on these loans.

Then came a phase when the demand for MBS grew even more. Retail and commercial banks wanted to keep up. Therefore, they started issuing loans without even checking borrowers' credentials.

In this way, the list of borrowers was increasing at the desired rate.

7. Collateralized Debt Obligations (CDOs)

When retail banks started lending to less reliable borrowers, investment banks knew the risk. They could measure that these borrowers have a high probability of defaulting. Overall MBS credit ratings were dangerously low (such as B+, CCC and below).

So what they did is they created another investment vehicle called the CDO. These CDOs held a mix of mortgage-backed securities:

• Hipotecas Prime (A a AAA Credit Rating)
• Subprime mortgages (credit rating A- and below).

This helped them hide so-called “subprime mortgages” under the guise of prime mortgages.

Furthermore, CDO buyers were no ordinary men. They were mainly acquired by hedge funds, investment banks themselves, pension funds, etc.

Therefore, public auditing of subprime mortgages could be avoided. Investment banks could keep it hidden for a long period of time.

Investment banks, however, were not so bothered. Why? Because there was a market for the aforementioned MBS and CDOs. People bought their shares with open arms.

8. Rising real estate market

As more people became eligible for mortgages, the demand for homes began to increase. More people had money (borrowed) to buy a new house.

This created a real estate price bubble. The price of residential real estate has only gone up. In such a thriving market, the pretense has been created that nothing can go wrong with MBS. How?

What was MBS' source of income? Borrowers make monthly payments against the mortgage loan. The risk of loss here was only when borrowers defaulted (loan default).

For the MBS market this was not a problem, why? Because the property that was used as collateral could be sold to offset the loss.

That assumption wasn't wrong, but it stayed true only until house prices rose.

9. Role of other agencies

In 2008-09, most borrowers were in default. Insurers (such as AIG) could not cover this urgency. They also filed for bankruptcy.

10. Why do people take out loans?

Back then, even people who had no source of income could get loans to buy houses. These people had almost no ability to pay the mortgage, yet they took the loan anyway. Why?

Their rationale was that since house prices were only going up, they could use that to their advantage. Example: Take out a $100,000 loan and buy a house. After a few months, sell the house for $102,000. Use the proceeds from the sale to pay off the loan and save the balance as a profit.

People took out mortgages to trade real estate. To help these borrowers, banks have offered incentives. The loans had lower monthly payments for the first few months.

11. Real estate bubble burst

A stage has been reached in the US housing market where borrowers have begun to default on their loans. Why the default? Because it was inevitable. How?

The cause was subprime mortgages. Loans were made to people who had little ability to repay the loan. So they ended up being unable to make the "monthly payments" and their estate was foreclosed on.

At one point in 2007-2008, there were more homes for sale than buyers. This caused a steady drop in prices. The real estate bubble burst.

12. More bad loans

When house prices started to fall, people who bought houses for the sole purpose of “buying low and selling high” stopped paying their mortgages. Why?

Because the value of your property started to be less than the mortgage value. This led to more loan defaults, which led to more foreclosures. This further reduced property prices.

13. What the big investors did made the situation even worse

When financial institutions saw this downward price trend, they became defensive. They stopped buying shares of subprime mortgage-backed securities.

Instead, they started doing the opposite. They began to unload their shares already held in CDOs that had subprime mortgages as assets.

As a result, the stock price of MBS began to drop sharply. This eventually began to rub off on Wall Street.

Who were these big investors? They were investment banks like Lehman Brothers, Bear Sterns, etc.

In this way, the profits of investment banks (MBS) stopped and eventually they had to declare bankruptcy.

14. The recession has arrived

Panic spread first among ordinary Americans and then across the world. The stock market crashed and the credit market froze.

Loans became almost impossible to obtain. Economies around the world have run out of cash. In the absence of sufficient liquidity, growth rates turned negative.

Due to the negative sentiments, public spending was also falling. This eventually led to a recession.

Conclusion

To make the whole story short, let me list the main causes that led to the formation of subprime mortgages and ultimately the financial crisis of 2008:

• bad loans: The root cause of the crisis was “bad loans”. If retail banks had refrained from issuing bad loans, CDOs based on subprime mortgage-backed securities would never have been born.
  • Why do retail banks issue bad loans? Because they knew that the responsibility for the bad loans would not be theirs (it would be the investment banks). His risk of loss was almost zero. Also, there was a demand for subprime mortgages, and they also got higher interest rates for banks.
• investment banks: Forming CDOs on subprime mortgages was his first mistake. The second mistake (which also amounts to a crime) is hiding the true credit rating of CDOs and MBSs.
• insurers: Insurance cannot be sold to anyone. Just as a cancer patient won't be able to buy health insurance, unhealthy CDOs shouldn't have gotten the protection of credit default swaps either.
• rescuing: The US economy is huge. It's so big that even a small change here affects economies around the world. Furthermore, in the modern economy, banks simply cannot fail. Many people depend on even the basic functions of banks. So, in the back of their minds, the banks knew that the US Congress would eventually bail them out.
• Congress and SEC: First it was the US Congress that restricted the SEC's powers over the regulation of MBS, CDOs and Credit Default Swaps. The Department of Justice (DOJ) was also silent in the face of congressional and SEC wrongdoing.
• People: It won't be wrong to say that ordinary people also contributed to the subprime mess. People who knew they wouldn't be able to make their monthly mortgage payments shouldn't have taken out the loan in the first place. His greed for easy money made things worse.

Last words

What have we learned from the subprime mortgage crisis? Probably little.

After the 2008 financial crisis, subprime mortgages disappeared from the US market. There were many critical eyes, watching the investment banks' next steps.

Even the SEC was cracking down on retail banks, which were the first window for lending to the public. But today, in 2019, banks may have found another loophole in the law books.

A type of loan very similar to Americans is being issued again. Instead of calling it "subprime mortgage", it was renamed to "student loan debt'.

Mainly, student loan debt is not a bad thing. But when the size of that debt reaches $1.5 trillion, questions arise.

What is most worrisome about student loan debt is its "burden" on students. In 2019, 44 million students would have benefited from student loans. On average, each student has a loan load of $32,000.

Starting a race with that kind of load is a concern.