Many factors contributed to the collapse of the US subprime market in 2007. In this article we will show how borrowers, financial institutions, mortgage brokers, underwriters, credit rating agencies, and other factors, have contributed to the failure of the US subprime market.
The housing bubble in the US was a consequence of the escalating house prices. They rose 124% during the period between 1997 and 2006. The failure of the subprime market started with an entrepreneur who realised that he could profit by the demand supply gap that existed between people who wanted to buy a house and financial units that could finance them.
The problem stemmed from the fact that loans were available to customers at very high interest rates due to their low credit worthiness. The entrepreneur could borrow at a low rate of interest from investment banks possessing a higher credit rating.
The entrepreneur then made loans at a higher interest rate to those who wanted to purchase a house. An important feature of such loans is that they can be refinanced.
Also, in the beginning two to three years of the loan, the interest rates are low and kept at a fixed level. With time, the interest rate becomes volatile, and tends to shoot upward.
Refinancing is easy when the real estate market is undergoing a booming phase. For the borrower, the cost of the loan does not seem high since he can refinance his loan at an interval of two years. The entrepreneur, on the other hand, issues mortgage backed securities in order to secure his loans.
The investors are also paid a certain amount of money in the form of interest. The money that is generated from the loan is used by the entrepreneurs to repay back the loan taken from the investment banks. The payment of interest as well as the principal amount to the investors comes from the installment payments of the home loan borrowers.
The problem arises when the interst rates rise abnormally high. The immediate effect is the fall in the price of real estate. The home loan borrowers are in financial trouble. They are unable to pay the high installments for the loan, and at the same time it becomes difficult for them to refinance, due to the falling real estate prices. With the default of the borrowers, interest payments that are given to the investors are not met. In such a case the borrowers turn to the entrepreneur, and he has no option but to file for bankruptcy. This is how the inability on the part of the borrowers to repay back the loans led to the failure of the US subprime market.
The mortgage brokers do not loan money out of their own pockets. The riskier the loans they are successful in selling, the more the commissions will be for them. According to the Chairman of Mortgage Brokers Association, the mortgage brokers benefited from the housing loan boom in the US, but they never checked the repaying capacity of the borrowers.
There is one school of thought that holds government policy responsible for the failure of the US subprime market. The Community Reinvestment Act forces the banks to lend to individuals who have a low credit rating. The Central Bank shows even less concern for avoiding asset or housing bubbles. They have not, to date, attempted to identify the asset bubble or formulate any proper monetary policy to deal with the existing situation.