Question

What were the mechanics of Subprime Mortgage crisis? Why it happened

Consider me a non financial person and  make sure that I get it early. Subprime mortgage crisis 2008

Housing bubble in USA

Answer 1

I would like to narrate it in a simple and short way

Financial sector was deregulated in US, which allowed banks to indulge in derivative trading, on the pretext by the banks that they need to compete internationally and do more profitable business.

So they created a derivative called as mortgage backed security (MBS). A derivative is a financial instrument which gets it's value from a underlying asset. A MBS derived it's value from mortgages.

The process is that the banks would sell the loans (backed by the mortgages) lent by it to hedge funds.

Hedge funds would buy the various loans from banks, bundle it as a package, divide the package into a number of units, called derivatives (MBS), whose value depends on the underlying mortgage value, and the derivatives to investors all over the world.

In this way both banks and hedge funds were risk free.

In due of time, the derivative became a very popular financial instrument to invest in, because it is secured by mortgages.

Due to increase in demand for derivatives, banks wanted more and more mortgages, to back the derivatives. Hence they started giving housing loans to subprime borrowers i.e borrowers who have poor credit record at low interest rates, which prompted more sub prime borrowers to take the loan and buy the house by pledging the houses as collateral to banks.

Then the FED hiked the interest rates, which the subprime borrowers couldn't repay. Hence the bank took over most of the houses of subprime borrowers and auctioned it for sale.

But due to huge supply of houses and low demand, the prices started falling and nothing could be realised from houses. Hence all loans became bad debts, hence the derivative (MBS) lost it's value, because the loans became worthless.

Hence the investors all over the world, who invested in these derivatives lost their money, leading to the global financial crisis or the subprime crisis.