How to Explain the Subprime Crisis in simple terms part 3

So now that we understand what sub prime loans are and how they are packaged up into pools and resold, we can now look at how the sub prime crisis happened. By late 2004 the US economy was growing fast enough that the federal reserve decided to start raising interest rates, which it has continued to do until fed funds rate stood at 5.25% in January of 2007 (up from 1%). Several things happened as a result of this.

1. It became much more expensive to borrow money so less people could afford to buy a house and those that could, could not afford as large a mortgage as they could when rates where at 1%.

2. As there were not as many buyers, the real estate market began to cool and house prices which had been increasing rapidly in the years leading up to this began falling moderately.

3. If you remember correctly from our first article many of the sub prime borrowers took out adjustable rate mortgages where payments rose if interest rates rose and low initially fixed rate mortgages that quickly converted to adjustable rate mortgages. Their plan was to refinance these loans using the expected increase in value of their house to help them qualify for a better loan. As the housing market stalled however and their houses were no longer increasing in value, they could not refinance and therefore were stuck having to pay a much larger mortgage payment as the harsher terms of the loans they agreed to kicked in. This caused many of these borrowers to not be able to make their house payment and therefore their house was foreclosed on.

So the issue now is that there are billions of dollars in losses relating to rising defaults mostly related to sub prime borrowers.

From the financial institution side of the equation, the problem would be bad if everyone knew where all these loans were, which financial institutions and investors were going to loose money as a result of this, and how much money they could potentially loose.

If you remember from our second lesson however, these loans were for the most part no longer with the financial institutions that made the loans but had been sold off and traded among different financial institutions from around the world. As the subprime portion of these mortgage pools were defaulting at a much faster rate than expected, the institutions that held them stood to loose a lot of money as a result.

This has caused what is known as a liquidity crisis where no one trusts anyone else enough to lend them money at reasonable rates, even the largest banks in the world. This is a real problem for these banks, who basically are the financial system, because they rely on large short term loans from one another to cover their short term expenses.

Because these institutions are normally considered very credit worthy, and because these loans are short term, they normally come with a very low interest rate. As no one knows who has been left holding the bag with the subprime debt, the interest rates that are charged on these loans have gone through the roof.

This is why you read about the different central banks around the world having to step in and add liquidity to the market by basically injecting billions of dollars into the financial system to try and keep things from locking up.

If you also remember in our second lesson we learned about these huge pools of pools which are known as Structured Investment Vehicles. If you remember from that lesson these entities rely on this short term borrowing to buy the longer term debt and have to periodically roll the loans they are issuing over. The problem now is that they can no longer borrow short term to cover their obligations and are therefore in danger of having to sell off huge chunks of these mortgage backed securities to avoid running into financial difficulty. This is why you read about banks like Northern Rock having to be bailed out by the Bank of England and Citigroup having to raise billions of dollars from the Abu Dhabi Investment Authority.

As there are so many problems with the mortgage market right now however the market for many types of these pools has dried up as no one wants to buy them. This means that if these institutions are forced to sell they are going to have to do so at very low values in relation to how much the pools they own are probably still worth even with the problems. What this has caused is a situation where everyone that can is holding on hoping that the market will return to normal so they can exit their positions at a reasonable price.

Lastly and perhaps most importantly because the market for many of these pools has dried up, it is very difficult to tell how much they are worth. This has brought a lot of suspicion to even those who have come clean about how much subprime exposure they have, and how much the losses are they plan to take as a result, because there is really no way to know for sure if they have valued that loss correctly until the market returns to normal.

Currently there is still a lot of uncertainty as to when this will end and how bad it is going to end up being for the economy. All I can say here is that time is the key factor. If the banks and other financial institutions that are holding this bad debt come to a consensus on how much of it they are going to have to write down and how they are going to value the losses quickly, then things will be a bit painful in the short term but better over the long term. If there is no consensus on where and how much the losses are after the first quarter of next year, then we are probably in for lots of trouble and markets will head lower as a result.