St. Paul University DumagueteCollege of Business and Information Technology

Origins

How did a crisis in the American housing market threaten to drag down the entire

global economy? It began with mortgage dealers who issued mortgages with terms

unfavourable to borrowers, who were often families that did not qualify for ordinary home

loans. Some of these so-called subprime mortgages carried low “teaser” interest rates in

the early years that ballooned to double-digit rates in later years. Some included

prepayment penalties that made it prohibitively expensive to refinance. These features

were easy to miss for first-time home buyers, many of them unsophisticated in such

matters, who were beguiled by the prospect that, no matter what their income or their

ability to make a down payment, they could own a home.

Mortgage lenders did not merely hold the loans, content to receive a monthly

check from the mortgage holder. Frequently they sold these loans to a bank or to Fannie

Mae or Freddie Mac, two government-chartered institutions created to buy up mortgages

and provide mortgage lenders with more money to lend. Fannie Mae and Freddie Mac

might then sell the mortgages to investment banks that would bundle them with

hundreds or thousands of others into a “mortgage-backed security” that would provide

an income stream comprising the sum of all of the monthly mortgage payments. Then

St. Paul University DumagueteCollege of Business and Information Technology

the security would be sliced into perhaps 1,000 smaller pieces that would be sold to

investors, often misidentified as low-risk investments.

The insurance industry got into the game by trading in “credit default swaps”—in

effect, insurance policies stipulating that, in return for a fee, the insurers would assume

any losses caused by mortgage-holder defaults. What began as insurance, however,

turned quickly into speculation as financial institutions bought or sold credit default

swaps on assets that they did not own. As early as 2003, Warren Buffett, the renowned

American investor and CEO of Berkshire Hathaway, called them “financial weapons of

mass destruction.” About $900 billion in credit was insured by these derivatives in 2001,

but the total soared to an astounding $62 trillion by the beginning of 2008.

As long as housing prices kept rising, everyone profited. Mortgage holders with

inadequate sources of regular income could borrow against their rising home equity. The

agencies that rank securities according to their safety (which are paid by the issuers of

those securities, not by the buyers) generally rated mortgage-backed securities relatively

safe—they were not. When the housing bubble burst, more and more mortgage holders

defaulted on their loans. At the end of September, about 3% of home loans were in

the foreclosure process, an increase of 76% in just a year. Another 7% of homeowners

with a mortgage were at least one month past due on their payments, up from 5.6% a

year earlier. By 2008 the mild slump in housing prices that had begun in 2006 had

become a free fall in some places. What ensued was a crisis in confidence: a classic

case of what happens in a market economy when the players—from giant companies to

individual investors—do not trust one another or the institutions that they have built.

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