Subprime mortgage crisis

Mortgages

• A debt instrument, secured by the collateral of specified real estate property, that the borrower is obliged to pay back with a predetermined set of payments
• Debt instrument
• A tool an entity can utilize to raise capital
• e.g., credit cards, credit lines, loans, and bonds
•  If the borrower stops paying the mortgage, the lender can foreclose. 

Investment Banks & Mortgages

• Since year 2000's, investment banks have bought the “mortgage agreements” from the retail banks.
• This way, they become entitled to receive the monthly payments from the borrowers.
• Why investment banks buy loans? 
• To use them as Mortgage Backed Security (MBS).
• In traditional banking, there are only two agencies dealing with loans – borrower and lender (homebuyer and retail bank)
• But since year 2000’s, a third party got involved – investment banks.

Mortgage-Backed Securities (MBS)

• In year 2000's, (Investment) Bankers were busy inventing a low risk – high return investment option.
• The yield of government back securities (like treasury bonds) was very low.
• This gave rise to mortgage backed security (MBS).
• At a time when treasury bills were yielding less than 3.5% returns, MBS could promise 5-6% fixed returns.
• As MBS had ‘mortgage loans’ as their assets, it was considered safe.

How Does IB use MBS to make money?

• Several such mortgages that IB bought from retail banks were then clubbed together to form a Mortgage Backed Security (MBS). 
• This MBS was valued based on its future income potential, i.e., monthly payments received from the homebuyers.
• One MBS was divided into a multitude of share to be sold to many investors 
• These shares of MBS were then traded in secondary market (Wall Street).

Increased Demands for MBS and Loans to People with Low Credit Scores

• The demand for MBS skyrocketed.
• It was a perfect investment vehicle for matured economies (like USA, UK, Australia etc). 
• To feed the rising demand, MBS needed more mortgages.
• Retail banks started issuing loans (i.e., mortgages) to even not so credit worthy borrowers.
• But they charged higher interest rates on such loans.

Collateralised Debt Obligations (CDO)

• When retail banks started issuing loans to less credit worthy borrowers, investment banks knew the risk
• i.e., the high chance of default
• They created another investment vehicle called CDO’s.
• CDO
• Financial tools banks use to repackage individual loans into a product sold to investors on the secondary market, i.e., typically think of as the "stock market"
• A particular kind of derivative—any financial product that derives its value from another underlying asset.
• These CDO’s had a mix of mortgage backed securities
• Prime mortgages (Credit Rating A to AAA)
• Subprime mortgages (Credit Rating A- and below).
• This helped them to hide the so called “subprime mortgages” under the blanket of prime mortgages.
• The buyers of CDO’s were not common men. 
• They were purchased mainly by hedge funds, investment banks themselves, pension funds etc.
• Hence the public audit of subprime mortgages could be prevented. 
• Investment banks could keep it hidden for extended period of time.

The Boom of Real Estate Market

• As more people were becoming eligible for the mortgage, the demand for homes started increasing.
• This created a price bubble in the real estate sector. 

Credit Default Swaps

• Credit default swaps are basically insurance cover for the MBS.
•  It agrees to pay the outstanding amount of the bond if the lender defaults.
• In 2008-09, majority borrowers were defaulting on loans. 
• The insurance companies (Like AIG) could not cover this urgency. 
• They also declared themselves as bankrupt.

The Logic of Sub-prime Mortgages Borrowers

• They had near zero capability to payback the mortgage
• Their logic was, as the price of homes were only going up, they can use it to their advantage.
• e.g., Take a $100,000 loan, and buy a home. After few months sell the home for $102,000. Use the sale proceeds to pay back the loan, and pocket the balance as profit.

Bursting of the Housing Bubble

• The borrowers started defaulting on their loans.
• The cause was subprime mortgages.
• At a point in 2007-2008, there were more houses on sale than there were buyers for it. 
• This triggered a steady price fall.
• Because their property value started becoming smaller than the mortgage value. 
• This led to more loan defaults, leading to more foreclosures. 
• This further brought down the real estate prices.