Hedge Fund Articles


The Subprime Mortgage Crisis – What Happened

In 2007, it was impossible to turn on the news without hearing about one of two things. Britney Spears, or the subprime mortgage crisis. While both debacles got an equal share of press and public scrutiny, the subprime mortgage crisis is still reeking havoc on the economy, and so far, has cost banks upwards of $285 billion. It was the culprit of many failed hedge funds and other investments, it fueled the collapse of Bear Stearns and other large institutions, and its aftershock is still being felt in all corners of the world. So what was this “crisis” that everybody was moaning about? How did it begin? Let’s take a look back.sunny-isles-condos.JPG

In 2005, the housing market was booming. I can remember living in Miami, looking at one-bedroom condos, and not being able to get near them for less than $350,000. Demand was sky-high, and people who had purchased their homes for $150,000 a few years back, were suddenly making a killing on flipping them. Developers saw this demand and got greedy. Overnight it seemed, the skyline of Miami was flooded with cranes, and residential condos were being built on nearly every corner. Thousands of new units were springing up, leaving the obvious question: Are there enough buyers? The shortened answer was: No. This wasn’t confined to southern Florida, either. The entire country was experiencing the same dilemma on some scale.

Desperate to rent out these units, banks started lending to anyone and everyone that wanted to buy a home, even people with ugly or no credit. These “subprime” candidates were often misled, with banks offering them attractive interest rates up front, and failing to convey that these low interest rates would increase after an initial period.

According to an article published on subprimelosses.com, the amount of mortgages that reset to higher interest rates are as follows:

Month Approximate Amount of Mortgages Resetting to Higher Rates January 2007 $27 trillion February 2007 $23 trillion
March 2007 $26 trillion
April 2007 $38 trillion
May 2007 $38 trillion
June 2007 $38 trillion
July 2007 $44 trillion
August 2007 $44 trillion
September 2007 $48 trillion
October 2007 $50 trillion
November 2007 $46 trillion
December 2007 $41 trillion
January 2008 $44 trillion
February 2008 $32 trillion
March 2008 $37 trillion
April 2008 $46 trillion
May 2008 $40 trillion
June 2008 $32 trillion
July 2008 $35 trillion
August 2008 $37 trillion
September 2008 $30 trillion
October 2008 $18 trillion
November 2008 $14 trillion
December 2008 $12 trillion

Inevitably, these individuals started defaulting on their mortgages due to higher interest rates, and the fact that they probably couldn’t afford them in the first place.

To make matters even worse, the supply of open residential units far outweighed the demand. People who couldn’t pay their mortgages were unable to sell their homes, or took huge losses due to declining home values. The result was an overwhelming number of foreclosures. Many buyers purchased second homes, thinking they would flip them and make a quick buck. Most of these buyers already had another mortgage to pay, and couldn’t afford both.  This resulted in more foreclosures.

Meanwhile, subprime mortgage-backed securities, investment vehicles which derived their values from underlying mortgages, gained wide circulation within the investment community.  Asset-backed securities such as Collateralized Debt Obligations, in particular, became popular with hedge funds. Some feel that ratings agencies like Moody’s perpetuated their popularity by presenting these securities as having little risk, while they were in fact, extremely risky.

The biggest problem of the subprime crisis was the domino effect it had through the world’s economy. Because so many investment vehicles were dependent on these mortgage-backed securities, assets started to plummet when all of these foreclosures starting happening. While ratings agencies have started to adjust their ratings, banks are tightening their underwriting standards, lending less, and building up their depleted reserves. We will probably still feel the wrath from the subprime crisis for months, if not years to come.

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