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Editor’s Note: This article is part of a series on the geopolitics of the global financial crisis. Here, we examine the roots of the current financial crisis in the United States.
The root of the American credit crisis is similar to that of previous recessions. As profits pile up during economic expansions, investors eventually find it difficult to find investments that generate large returns, so they send their money after riskier prospects. In the expansion that just ended, the most important of those questionable investments was subprime mortgages, culminating in mortgage loans that required minimal to nonexistent credit checks, down payments or even proof of income. In total, some $550 billion of subprime loans (and a separate $725 billion of Alt-A loans — the next quality step up from subprime) are currently outstanding.
The worst of these mortgages granted very low teaser interest rates that adjusted to normal rates after a period of two to five years; there were some $350 billion of these in subprime, and an additional $385 billion in Alt-A. While virtually none of these questionable-quality mortgages have been granted since the credit crunch began roughly a year ago, those resets are now weighing heavily on the housing market. As the rates reset, borrowers with questionable income and credit are often unable to meet the new, grossly enlarged payments based on the new rates. The result is a cascade of foreclosures that gluts the housing market, pushing prices down. So far $55 billion of subprime mortgages are in foreclosure, and just over another $80 billion are in severe delinquency. The numbers for Alt-A are $40 billion and $45 billion, respectively.
Under normal circumstances, this is more or less where things would have ended: A glut in regional housing stocks where subprime mortgages were most overused — especially in the Southern California, Las Vegas and Miami regions — would lead to a recession in those housing markets and perhaps some leakage into the broader national housing market.
But there is another step in the process that made the problem bigger. Mortgages are only rarely kept by their issuers — instead they are bundled into packages and sold to interested investors. This serves three purposes. First, since the mortgage maker can sell his loan for a profit, he can then turn around and make another mortgage. Second, this secondary tier of investors brings an entirely new source of capital into the market. Third, these packaged mortgages can be sold to yet more investors, creating a new series of mortgage-backed assets (and securities) that can be traded abroad. Taken together, this widens and deepens the capital pool and reduces mortgage rates for everyone.
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