2008 Mortgage Crisis

According to Paul Krugman, Nobel economist, “America in 2008 was looking like the Bernie Madoff of economies: For many years it was held in respect, even awe, but it turns out to have been a fraud all along”. The 2008 recession that crippled the American financial market was mainly caused by the subprime mortgage crisis. “A mortgage is a debt instrument, secured by the collateral of a specified real estate property, which the borrower is obliged to pay back over a set period of time” (Investopedia). As a mortgage is a type of debt, banks only provided mortgages to customers with a good credit score in order to reduce the risk of not being repaid. However, in cases where banks provided a mortgage to customers with poor credit scores, they charged …show more content…
Lenders took advantage of this housing market boom and started to offer high-risk mortgages to families that would normally not qualify for mortgages. The mortgages offered to high-risk families were called subprime. Lenders repackaged these mortgages into pools and sold them to investors in order to fund these mortgages (Duca, 2013). These mortgages became a new type of financial security, called mortgage-backed securities, and they were actively bought and sold in the stock market in order to fund these mortgages. The demand for these high-risk mortgages increased substantially, which resulted in increasing house prices, especially in areas with low supply of houses. This induced more expectations of housing price gains, thereby increasing the demand for houses (Duca, 2013). This cycle led to the housing bubble of the mid-2000s, depicted in Figure 1, where subprime mortgages grew a record 300% from $173 billion in 2001 to $665 billion in …show more content…
Mortgage-backed securities provided them with the perfect opportunity to earn a high profit because the rising house prices protected them from losses. When subprime mortgage borrowers were not able to make their loan payments, they would either sell their homes at a gain and pay off their mortgage, or refinance their mortgages by borrowing more against their increased house value (Duca, 2013). This led to an increased demand for mortgage-backed securities and inflated their values in the stock market. There was no precedent for this period of rising home prices and expanded mortgage availability, therefore the sustainability and risk of mortgage-backed securities was not well-understood. Investors therefore thought that these mortgage-backed securities were the perfect vehicle for them to generate high returns at a seemingly low