Subprime debacle FAQ

A series of questions asked privately:

– what is sub prime lending and the issues surrounding this.

Generally speaking, subprime lending is lending to borrowers whose creditworthiness is doubtful. In the specific context of the recent subprime debacle, subprime lending that experienced problems was mortgage lending to individuals with low credit scores and poorly (if at all) documented income.

– how did the crisis begin? what happened?

To understand what happened, you need to start with understanding the normal rules of asset-based lending. Let’s say you’re a banker. You give someone a loan to buy a house. If the borrower can’t make payments, you repossess the house and sell it. For a very long time, bankers kept in mind that it is entirely possible for the house to lose value between the time a loan was given and the time the borrower defaulted. So to protect themselves against large losses in a declining market, banks never lent more than 80% of the house value.

Now let’s fast forward to 1998. Home prices begin to increase very rapidly. After a few years of record-breaking price growth, the bankers suddenly realize that they don’t lose anything on foreclosures, even if they lend 90% or even 100% of the house value. (Some non-bank mortgage companies eventually went as far as 120% loan-to-value.) So all of a sudden lenders found themselves in a situation where they can make easy money by lending to anyone. If the borrowers pay, good for them; if they default, the hungry market will snap up any number of foreclosures at very attractive prices. Or so it was thought at the moment…

Now recall that a lot of these new borrowers are subprime; they got themselves talked into adjustable rate mortgages, which have a low interest rate, but this interest rate is not fixed; it is tied to an interest rate benchmark (such as the prime rate) and changes with it. Interest rates, meanwhile, bottomed out in 2002 and rose almost two percentage points by mid-2006. It doesn’t sound like a big deal, but on a $200,000 adjustable rate mortgage it could easily add $200 to the monthly payment. Throw in the grim job outlook, and you can see why defaults began to happen increasingly often among subprime borrowers. Defaults rise, but prices begin to decline, as anyone who wanted a house seemed to have one. Lenders get stuck with foreclosure properties, which they can’t sell unless they drop the price and lock in a loss.

– how could the crisis be stopped from happening? (better credit scoring? credit risk management?)

I honestly don’t know. A lot of what was going on seemed to be bordering fraud anyway (from dubious appraisals to fuzzy credit ratings of mortgage-based securities), so another regulation may or may not have changed anything, especially since a lot of subprime lenders (Countrywide being the prime example) were not banks and were thus out of regulatory purview of the Federal Reserve.

– what happened after the crisis? (recent events)

Too soon to say: the crisis isn’t over yet.

– who was affected and why?

A lot of people… Subprime borrowers (primarily working-class people who saw a chance at home ownership and seized it without thinking through the consequences), subprime lenders, homebuilders, buyers of bonds into which subprime mortgages were repackaged (which included insurance companies, mutual funds, and foreign banks), you name it…

– WHAT ARE THE LESSONS to be learned for the subprime lending?

Any lesson you can draw from the subprime lending debacle today you could learn by reading Hyman Minsky in 1980s… To borrow a description of Minsky’s views from Nassim Taleb, “stability and absence of crisis encourage risk-taking, complacency, and lowered awareness of the possibility of problems” (The Black Swan, p.78). This is exactly what has befallen both subprime borrowers and subprime lenders.

i would be deeply grateful for a DETAILED explanation on this. also with sources/references to it would be helpful.

Minsky’s Financial Instability Hypothesis is a great starting point…

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