One of the main reasons for the Global Financial Crisis (GFC) 10 years ago was a big credit crunch due to easy money which led to a very overvalued housing market. Like with every other bubble before it had to burst, which resulted in a loss of confidence by US investors in the value of mortgages and in particular in the quality of subprime mortgages.
As the value of houses fell strongly, the home owners or borrows found themselves with negative equity (the house worth less than outstanding loan) and an increasing number of borrowers were defaulting on their loans. The banks were than faced with the problem that the houses were worth less than the money they have loaned out originally which eventually resulted in the subprime mortgage collapse. This of course was further magnified as these loans were packaged into exotic structured products and sold to investors around the world. This put the U.S. and most of the world into recession, causing many banks to fail globally, only to be bailed out by their governments.
Mortgage back securities and specifically the more exotic subprime mortgage back ones, are examples of derivative securities – something derived from an underlying security. Subprime mortgage structured products are exotic examples of sometimes very complex financial products. These are produced by banks and other institutions to protect themselves from the risk of investments going bad and moved off their balance sheets.
For example, when the bank loans money to a home owner, they are accepting a certain level of risk that the borrower pays the interest. In addition, the loans deplete the banks cash reserves and it also increases the banks risk because that loan might not be repaid. To balance that risk, many institutions would combine their mortgages together and then offer that as a product and sell the mortgages of their books. This product will decrease their overall risk in case of a single default for the investors and free up capital for the banks.
While nothing is wrong with this basic idea – it did initially make sense – when the banks started creating more and more complex mortgage backed securities, on top of other complex subprime mortgage backed securities they were building a giant trillion dollar tower of cards.
And then the bubble started to unravel and house prices started to fall. After years of easy loan approvals and increasing real estate prices, many people found themselves with an upside down mortgage and just walked away. In the US mortgages are non-recourse loans which means the owners just walk away from the home, leaving the banks or the investors of the mortgage back securities holding the asset in a market that continued to fall. This would then push more houses on the market as the banks tried to recover some of their loss, decreasing the market even more.
This spiral continued and the mortgage backed securities that were once a cash generating machine became an insatiable monster that consumed banks, pension funds, and even a few governments.