The Sub Prime Mortgage Crisis

As Europe teeters on the edge of another financial crisis it is probably prudent to remind ourselves what caused the last financial crisis just two years ago. In 2008 shocked observers around the world watched credit dry up and strong international financial institutions teeter on the brink of bankruptcy as government grappled with unprecedented choices like which banks had to be considered too big to fail. How alarming and dangerous state of affairs come to be?

Beginning in mid-2000 the American economy began to be awash in cheap money.The Federal Reserve incrementally lowered interest rates from 6.5% in May 2000 to 1.75% in a year and a half.This enormous wave of liquidity was destined to have some powerful effects.The traditional American dream of home ownership fuelled a lending spree as bankers wrote sub-prime mortgages to increasingly unqualified borrowers without sufficient income, without assets, even without jobs.

By 2003 interest rates reached 1%.The loose credit environment pushed real estate prices increasingly higher and made mortgage investing steadily more attractive. Cheap money and easy credit made the sub-prime bandwagon increasingly crowded.Soon inventive bankers began to bundle and securitize mortgages as collateralized debt obligations (CDOs) along with other more exotic instruments.They began to change hands and their values to increase to increasingly insupportable levels.The SEC then lowered the capital requirements for the five largest investment banks, giving them permission to leverage investments up to 30 times.Bankers were making money hand over fist while blithely assuming their activities were essentially risk-free

It wasn’t long before the climate began to change.The housing market become saturated just as interest rates began to rise.By 2004 rates were 5.5% and held steady for the next three years.Home ownership peaked in 2004 and home prices began to decline.The construction industry began to contract and sub-prime borrowers began to default.

As the crisis began expanding lenders began to teeter on the edge of bankruptcy.Hedge funds owed more than $1 trillion on securities backed by sub-prime mortgages whose worth was collapsing.Banks and investment houses turned to governments to be bailed out.Lehman Brothers collapsed, Bear Sterns and Merrill Lynch were taken over and governments partially nationalized banks to stave off collapse.

The crisis was created by a variety of factors, working together to create a kind of perfect storm of finance industry disaster.Many of mortgage-backed securities which were discovered to be “toxic assets” were valued by the ratings agencies to be high quality investments, often of the very highest qualities.Many observers see this as amounting to little more than investment banks and other issuers merely paying off the agencies for favourable ratings.Many also believe that both deregulation and lax enforcement of existing regulations, changes obtained after sustained and expensive lobbying by the financial industry was a ticking time bomb which eventually went off in 2007.The expectation by large financial concerns that while they can keep their upside returns while being insulated from losses by government regulations acted to encourage excessive and unexamined risk-taking in pursuit of profit.

The short and long term effects of the sub-prime crisis will never be fully calculated.The collapse of the housing market, the millions of foreclosed homes, and the steep downturns experienced by the construction industry will have reverberating impacts for at least the next three years and possibly the next decade.New regulation of the industry to attempt to rein in future excesses, while loudly called for from certain circles face an uncertain future, will be heavily lobbied against, and even if enacted may be so watered down or made easily evaded by industry intervention to be essentially meaningless.Whether or not our economy will be any better protected against the next speculative bubble remains to be seen.Many observers are not optimistic and believe it’s only a matter of time before the nation is once again faced with a complex crisis brought on by people who have taken the money and run.