Sub-prime mortgages, the credit crunch and the great financial crash of 2008

The rise in mortgage lending in the US was the proximate cause of the 2007 credit crunch and subsequent financial crash of 2008. In a nutshell, speculative lending by US financial institutions, especially of mortgage-backed collateralised debt obligations (CDOs), created a vast housing bubble (see asset bubble) in 2001-06. When banks were deregulated in the 1980s, mortgage markets stopped being essentially national institutions and entered a new era of international bond markets in which mortgage debt began to circulate around the globe. This allowed originating banks to bundle up mortgages into bonds (mortgage-backed securities [MBS] and CDOs) and to sell them on to institutional investors such as insurance companies and pension funds, looking for what they thought were long-term, secure assets. Unlike when they made loans to hold through to maturity, under this ‘originate to distribute’ approach, banks no longer risked making losses if the mortgage loan defaulted (Financial Crisis Inquiry Commission, 2011, p 89). This global circuit of mortgage debt fuelled the massive indebtedness of owner-occupiers in many Western countries in the 1990s and 2000s.

Numerous CDOs were guaranteed by monoline insurers who promised to reimburse investors for any losses on them, including the riskier tranches backed by sub-prime mortgages (loans granted to individuals with poor credit histories, who would not qualify for a conventional mortgage), in exchange for premium payments (see credit default swaps [CDS]). The percentage of sub-prime mortgages originated during a given year rose from about 8 per cent historically to approximately 20 per cent in the period from 2004 to 2006, with much higher percentages in some parts of the US. A large proportion of these sub-prime mortgages, over 90 per cent in 2006, were adjustable rate mortgages (ARMs), where the initial interest rate was fixed at a low level after which it was reset periodically, sometimes every month, at a variable, and often much higher rate (Wikipedia, Sub-prime mortgages).