The sign of the busting of bubble started to show from the middle of 2006 with the transition of loan from ‘interest only’ and ‘teaser rates’ to regular payments. This coupled with increase in market interest rate led to doubling or even tripling of monthly repayments. Unable to pay the increased monthly repayments, borrowers began defaulting and surrendering their houses adding to the pile of inventory of unsold houses. Unsold inventory was up nearly 40% in sept ’06, around the time when prices began to decline.
This put pressure on the other set of borrowers who had taken loan only because they believed that the prices would keep increasing and they would refinance their loan after the grace period of 12-24 months is over. However, the declining prices made it difficult for them to switch over and they surrendered their house to the banks. The vicious cycle of falling prices and rising defaults was gaining momentum. Number of defaults increased by as much as 80% in 2007 over previous year.
The cookie crumbled when the value of loan on the house became more than its market price. As per estimates, nearly 10% of houses were having negative equity in March’08 which stayed above 20% as late as Sept’10.
The impact had spread beyond the borrower and the lender by then. The increasing default meant the drying of cash flow to MBS owned by investors like hedge funds, investment banks and traditional banks. Most of these MBS were protected by CDS (Credit Default Swaps), a kind of insurance, implying that the issuer of CDS would pay up in case the mortgages pooled together in MBS defaulted. However, the wave of default was so huge that even insurers like AIG who had issued the CDS, without having adequate coverage, failed to honor their commitment. (Read more at – https://www.indiaeconomyandbusiness.com/subprime-crisis-ten-years/).
For the banking sector, this meant additional trouble since their equity erosion reduced their ability to lend to the rest of the economy. This marked the spread of contagion beyond the housing market. Worse, these MBS were owned by investors across the globe leading to spread of the crisis beyond US. The estimate of loss from the crisis stands at about $ 15 trillion of lost output. Value of listed stocks in U.S. declined from $20 trillion to $12 trillion between Jan-Oct’08 alone.
At the end, it was all manmade – at least an implicit, if not outright fraud. Goldman Sachs, one among many, paying a record fine of $550 million for providing incomplete information is a testimony to that. Rating agencies were another cog in the wheel who had rated most of these securities as triple A. More so, because a large number of investors, many not having sufficient understanding or the time to understand the financial markets, and the institutions who are required by their byelaws to invest in triple-A rated products, followed these ratings to make their investments. James Grant wrote in Oct ’06 how “Wall street transforms BBB minus rated mortgages into AAA rates tranches” by creating CDOs (quoted by Financial Crisis Inquiry Commission).
And this was aided and abetted by those who championed deregulation of financial market. If Warren Buffett says derivatives are “weapons of mass destruction”, probably Alan Greespan, the Fed chairman till 2006, helped drop that bomb on the US and the world economy..!
(Full report of FCIC – https://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf)