The subprime mortgage crisis has affected hedge funds, banks and insurance firms. Hedge funds and banks have been developing securities backed by mortgages. The insurance firms have credit default contracts to protect them. Demand for mortgages contributed to a housing asset bubble.
It sent adjustable mortgage interest rates skyrocketing as the Federal Reserve increased the federal funds rate. Home prices fell as a result, and investors defaulted. Derivatives spread the danger around every corner of the planet. That triggered the banking crisis of 2007, the financial crisis of 2008 and the Great Recession. It brought in the worst recession since the Great Depression.
1. Hedge funds played a vital role in this crisis
Hedge funds are still under immense pressure to achieve market out-performance. By pairing them with insurance called credit default swaps, they generated demand for mortgage-backed securities. What could go wrong? None, before the Fed started to increase interest rates. Anyone with adjustable mortgages will not be able to afford the higher payments. Demand has fallen, and so have house prices. They were defaulting because they couldn’t sell their homes either. No one will buy or sell securities which are now worthless. Yet the American Insurance Group (AIG) almost refused to cover the claims.
Deregulation was also triggering the subprime mortgage crisis. In 1999, it allowed the banks to behave like hedge funds. They have diverted funds from depositors into outside hedge funds. That is what sparked the 1989 Savings and Loan Crisis. Many borrowers have invested millions of dollars lobbying state governments to loosen rules. Such regulations should have prevented lenders from taking mortgages they couldn’t possibly afford.
2. Derivatives led the subprime crisis
Banks and hedge funds made so much money selling mortgage-backed securities that they soon created a huge demand for the mortgages underlying it. That’s what has continuously forced mortgage lenders to lower rates and conditions for new borrowers.
Mortgage-backed securities allow borrowers to bundle and resell loans into a kit. That helped banks to have more funds to lend in the days of traditional loans. It also shifted the possibility of lender defaulting as interest rates changed, with the introduction of interest-only loans. The risk was low, as long as the housing market continued to increase.
A further concern was the rise of interest-only loans paired with mortgage-backed securities. They brought so much market demand that it created a construction boom.
3. Subprime interest-only mortgage doesn’t work together
Subprime lenders are the ones with bad credit histories and therefore are more likely to default. Lenders are paying higher interest rates to offer more return on the greater risk. So, that makes making monthly payments too costly for many subprime borrowers.
The introduction of interest-only loans helped lower monthly payments so they could be borne by subprime borrowers. Yet, since the initial rates typically reset after one, three or five years, it raised the risk to borrowers. Yet borrowers were comforted by the housing market, which believed the borrower could resell the house at the higher price rather than default.
4. Collateralized debt obligation
The risk was not limited solely to mortgages. All types of loans have been repackaged and resold as collateralized debt obligations. As house values plummeted, many homeowners who used their homes as ATMs found they couldn’t afford their lifestyle any more. Defaults on debt of all sorts began to gradually creep up. Not only did CDO holders include borrowers and hedge funds. Corporations, pension funds, and mutual funds were all included. That broadened the risk for individual investors.
The biggest issue with CDOs was that consumers were unable to afford them. One reason they were so new and so complex. That was the stock market boomed.
The root cause of the subprime mortgage crisis is man-made greed and wisdom failed. The key players were banks, hedge funds, brokerage houses, rating agencies, tenants, creditors and insurance companies.
Banks offered loans, even to those who couldn’t afford loans. People were investing to buy houses even though they couldn’t afford them. The appetite for low premium MBS was generated by investors, which in effect boosted appetite for subprime mortgages. These were bundled in derivatives, and sold by financial traders and institutions as insured investments.
And when the housing market inflated and interest rates began to increase, people defaulted on their loans bundled into derivatives. That is how the housing market crisis took the financial sector down and sparked the Great Recession of 2008.