How to Explain the Subprime Financial Crisis Part 1

There is lots of news out about sub prime loans and the issues they are causing for the consumer, the economy, and in the financial markets in general. While I have seen a lot of coverage of recent events with subprime I have not found through my research many good resources for leaning about how exactly this all happened.

So in this three lesson series we are going to examine exactly how all this came about by looking at things from the borrowers side of the equation in this lesson, and then the lenders side of the equation in lesson 2. Then we are going to tie everything together in lesson 3 by bringing our newfound understanding of both sides together to understand exactly what caused the problem, what we are experiencing now, and what we are likely to see going forward.

A subprime loan is a loan given to borrowers that are considered more risky, or less likely to be able to make their loan payments, in relation to high quality borrowers because of problems with their credit history. When you go to get a loan you need to get a credit check, and what results from this credit check is something that is known as your FICO score. A FICO score is a number which represents how credit worthy you are considered which is based on factors such as the amount of money that you earn, your record of paying back past debts, and how much debt you currently hold. The higher the score the better your credit is considered, and the more likely you are to get a loan.

In order to understand how these sub prime loans have caused so many problems, we must first understand what happened in the years leading up to the recent problems. In the years leading up to the sub prime crisis interest rates (or the cost of borrowing money) had been at historical lows as the fed had aggressively cut interest rates to avoid going into recession after the tech bubble burst in 2000. While you don't need to understand all the details of the effects that low interest rates had you do need to understand two things:

1. When interest rates are low in general it causes the economy to expand because businesses and individuals can borrow money easily which causes them to spend more freely and thus increases the growth of the economy.

2. What drives interest rates lower is the fact that there is an increase in the supply of money, meaning that there is more money to go around.

Before the Fed lowered interest rates substantially after the bursting of the NASDAQ bubble in 2000, if you wanted to get a loan for a house you had to have a relatively good credit score. Buyers with a FICO score below 620 (generally considered sub-prime) where in most cases considered too risky to lend to and therefore could not get a loan.

After the fed lowered interest rates to historical lows however there was so much money (also referred to as liquidity) available that financial institutions started offering loans to buyers with FICO score's below 620. Because these borrowers were considered less likely to be able to pay the loan back than borrowers with higher credit scores, these sub prime borrowers were charged a higher interest rate.

Things initially went very well for the financial institutions that made these loans because in the years that followed interest rates stayed low, the economy continued to grow, and the real estate market continued to expand causing the value of most people's houses (including the sub-prime borrower's houses) to go up in value pretty dramatically. This made it relatively easy for these borrowers to make payments on their loans as if they ran into financial trouble they in more cases than not could tap the equity in their home (which came from the increase in the house price) to refinance at more favorable terms or to make their mortgage payment.

Because a relatively few of these sub prime borrowers were defaulting on their loans, the financial institutions which held these loans were enjoying the additional profits earned by charging these borrowers a higher interest rate, without many problems.

After the initial success and profitability for those offering sub prime mortgages the practice expanded dramatically and the terms which borrowers were given in order to allow them to obtain loans became all the more creative.

There are now many different types of sub prime loans such as:

Interest Only Mortgages: These loans require the borrower to pay only the interest portion of the loan for the first few years thus keeping the payment relatively low for the first few years before the interest only component expires and the borrower must pay the principle and interest component of the mortgage payment (of course a much higher amount)

Adjustable Rate Mortgages: Unlike traditional mortgages have a fixed interest rate so your payment is the same each month, with an adjustable rate mortgage if interest rates rise (as they have been recently) your monthly mortgage payment goes up as well.

Low Initial Fixed Rate Mortgages: Mortgages that initially have very low fixed rates and then quickly convert to adjustable rate mortgages. .

Because house prices had increased so rapidly in the last few years many of these sub prime borrowers took out loans that they could not afford in the anticipation that, when the mortgage reset to the higher payment, they would be able to refinance at more favorable rates using the increased value of their home and the equity that they now had as a result of that.

So now that we have a background on what was happening on the borrower's side of the equation the next thing that we will look at is what was happening on the lender side of the equation. Once we have a background there then we will tie everything together in the third and final article so you have a good understanding of all the factors at play here in the sub prime crisis.

As always if you have any questions or comments please feel free to leave them in the comments section below, and have a great day!