The credit crunch, how did it all begin?

A knock-on effect for credit markets and the wider world economy

As financial institutions globally announce varying degrees of difficulties and losses caused by toxic assets and bad debts held on their balance sheets and with the share prices of some of the UK’s largest banks falling to unprecedented levels, the word ‘subprime’ has become synonymous with these historic events.

The beginning of the subprime mortgage crisis can be traced back to 2001. During this year the US economy was first hit by the dotcom bubble crash, which was then followed by the events that took place on September 11th. In the wake of this, the US Federal Reserve dropped interest rates to 1 per cent, making borrowing cheap as the US housing market began to boom. Many mortgage lenders thought they saw a particularly lucrative market by lending to adverse credit subprime borrowers, because they would be able to charge higher interest rates to their higher-risk customers.

As house prices continued to increase until 2006, refinancing these mortgages through homeowner loans or remortgaging was relatively easy. However, house prices had increased sharply along with interest rates, and by the end of 2006 house prices began to deflate. Soon the US housing bubble popped and house prices slumped, leaving many people in a position where they found it difficult to refinance due to negative equity in their property. People began to default on their mortgages, and this became even more apparent during 2007 and 2008 with many more properties being repossessed as a consequence.

A considerable number of mortgage lenders who lent to subprime borrowers repackaged their debt as mortgage-backed securities (MBS). The cash flow of these had been backed by the principal and monthly interest payments of the mortgages. Because of the boom in the US housing market, many banks and hedge funds saw MBSs as good investment opportunities. However, when the cashflow on them stopped due to borrowers defaulting, the securities lost their value, resulting in huge losses for those that had invested in them. As a result these events have had a knock-on effect on credit markets and the wider world economy, and are the route of the current financial crisis we are experiencing.