Question

The volume of commercial and industrial loans made by banks has declined over the past few decades, while the volume of real estate loans has risen. Explain why you think this trend occurred and how it contributed to banks’ difficulties during the financial crisis of 2007-2009.

Answer 1

The financial crisis of 2007-09 was based on the rising real estate loans given out to sub prime lenders. This can be explained in simplified terms as follows :

All the banks earn money from the interest spread or the interest income they earn by lending and borrowing. Hence, they need to ensure that they are making more money than what they are spending (in the form of interest rates given on savings deposits, fixed deposits, etc ). Like any business, they also want to focus on opportunities where they can maximize their earnings while remaining within the given risk parameters (since banking is a highly regulated industry).

During the subprime crisis of 2007-09, banks saw high potential in the home loans segment since the property prices were soaring during the period and most people wanted to buy houses, even when they couldn't afford it in order to make money from rising property prices. Banks tapped into this demand and since property/land prices have historically been known to always appreciate over time, they concerned it a low to medium risk proposition and started handing to loans to even sub prime (not as highly rated as prime) borrowers at a much higher interest rate,

On the other side, to pay the high interest amounts on these loans,  firms and households started reducing their consumption expenditure and investments which further led to low demand for other types of loans. This started turning into a vicious trap for the banks until a point where the borrowers started giving up on their collaterals (properties/land in this case) to get out of loan repayments. This accelerated to such an extent that many banks were left with houses, which no one was willing to buy and were practically worthless for many of these banks.