Global Financial Crisis (2007-09) –
Burst of Sub-Prime Housing Bubble – The Origin of Crisis –
From the second half of 2007 in the United States a financial crisis started with a burst of housing bubble which led to widespread mortgage defaults and caused large losses to the banks and other financial institutions.
This crisis occurred due to sub-prime housing loans given on a large scale by the American banks in the past several years. But the foundation of this crisis were laid earlier. Housing prices in the US rose higher and higher during the early 2000s. Many people found themselves incapable of buying a house because monthly mortgage payments were too high relative to their monthly incomes. Since, housing prices were rising rapidly, the borrowers thought that they would sell their houses and make profits and would again get mortgage loans. While the money lenders (banks and other financial institutions) in order to make profits started to giving mortgage loans to the people who did not have adequate incomes to make monthly mortgage payments. Therefore, these housing loans have been called ‘Sub-Prime Housing Loans‘.
These sub-prime housing loans grew rapidly in the early 2000 in the United States. To cover the risks money lending banks and other financial institutions charged higher interest rates on them.
The question is why mortgage lenders gave such risky loans to sub-prime borrowers.
In words of Abel, Bernanke and Croushore, ‘To a large degree the answer is that they expected house prices to continue to rise rapidly in the foreseable future. As long as house prices kept rising substantially, a borrower who might otherwise have a problem in making mortgage payments in the future could either sell the house for a profit and pay off the mortgage or could borrow against the house’s equity value which would be higher as house prices increase further. So, both the borrowers and lenders thought that they were insulated from risk.
The IT bubble burst in 2000 pushed the American economy into recession. To get the economy out of the recession the US Federal Reserve cut interest rates bringing a large increase in liquidity (money supply) with the banks. With cheap availability of credit, the households even with poor credit worthiness borrowed funds from the banks to buy cars and houses. Americans went on a home buying spree. Prices of houses and real estate were rising rapidly. This increase in housing prices made both households and banks believe that their prices would continue rising. In view of low interest rates and excess liquidity with them lending for houses by banks was found to be quite attractive. As a result, banks provided housing finance even to sub-prime households (that is, households that had no capacity to pay back the loans on time).
This irresponsible behavior on the parts of banks was to provide loans to households or persons who had no income and no assets. All this went on well as long as housing prices were rising.
In the United States in 2005 mortgage interest rates across the country began to rise that caused slow down in the increase in the prices of houses. Building of houses in excess during the boom period led to their oversupply in the market which caused house prices to decline in 2006. Like the IT bubble, housing bubble burst in the second half of the 2007. With the fall in the prices of the houses which were held as mortgage the sub-prime households started defaulting on a large scale in making their installments. This caused heavy losses to the banks. With this the sub-prime housing market which had expanded on a large scale when there were low interest rates and huge amount of liquidity with the banks tumbled. The size of this sub-prime housing market was about 1.4 trillion dollars worth which was given as sub-prime loans by the banks earlier.
Aim Institute of Economics 