Oct 13, 2009
Sub prime
The global financial meltdown began with irresponsible lending of home loans to high risk borrowers in the United States, many of whom could not afford to repay them. These ‘sub-prime loans’ funded by easily available credit fuelled high house price inflation; higher house prices that were used to secure ever increasing debt.
The sheer quantity of subprime debt was built up over a very short period of time. In 1999, the Republican controlled Congress excluded banks’ investments in securities from the Community Reinvestment Act (which ensured access for low income and minority groups to the financial system, as well as stipulations on responsible lending). Over the course of the next seven years there was a surge in lending up to $600 billion in 2006—by which time such securities constituted one-fifth of mortgage originations.
The salesmen responsible for this surge received a generous commission for each new loan, paid upfront but expressed as a proportion of the redemption payments to be made over several years. Brokers happily signed up ‘ninjas’—no income, no job and no assets—by the hundred thousand. This behaviour was directly encouraged by their incentive structure, while legislation dating back to the 1960s had relaxed credit standards for the low paid and jobless without reckoning with the likely consequences. The quality of the arrangements made for poorer mortgage holders was manifestly inadequate, few of whom had any insurance provision. Subprime borrowers were lured into inherently bad deals by those low ‘teaser rates’ that bore no relation to the large payments required of them down the line, and started to cause defaults.
In March 2007, as the crisis was beginning to break, the value of US subprime mortgages was approximately $1.3 trillion, with over 7.5 million mortgages outstanding. These high risk sub-prime loans were bundled together with other home loans and converted into paper ‘asset-backed securities’ that were traded on the international financial markets; traders often earning millions of dollars in bonuses for trading them at a profit.
The sheer quantity of subprime debt was built up over a very short period of time. In 1999, the Republican controlled Congress excluded banks’ investments in securities from the Community Reinvestment Act (which ensured access for low income and minority groups to the financial system, as well as stipulations on responsible lending). Over the course of the next seven years there was a surge in lending up to $600 billion in 2006—by which time such securities constituted one-fifth of mortgage originations.
The salesmen responsible for this surge received a generous commission for each new loan, paid upfront but expressed as a proportion of the redemption payments to be made over several years. Brokers happily signed up ‘ninjas’—no income, no job and no assets—by the hundred thousand. This behaviour was directly encouraged by their incentive structure, while legislation dating back to the 1960s had relaxed credit standards for the low paid and jobless without reckoning with the likely consequences. The quality of the arrangements made for poorer mortgage holders was manifestly inadequate, few of whom had any insurance provision. Subprime borrowers were lured into inherently bad deals by those low ‘teaser rates’ that bore no relation to the large payments required of them down the line, and started to cause defaults.
In March 2007, as the crisis was beginning to break, the value of US subprime mortgages was approximately $1.3 trillion, with over 7.5 million mortgages outstanding. These high risk sub-prime loans were bundled together with other home loans and converted into paper ‘asset-backed securities’ that were traded on the international financial markets; traders often earning millions of dollars in bonuses for trading them at a profit.
