what is subprime mortgage crisis or 08' financial crisis?
In the previous page, we took a look at some of the examples of neoliberal practices. These policies left lasting influences on our society in general. In this page, I would like to delve into one example in particular, the 08' financial crisis, also known as the subprime mortgage crisis. Here is a simple account of how this crisis started.
Let's say that Tom is a prospective home owner. He does not have enough money to pay the price in full at once, so he gets a mortgage--which essentially is a debt--and in return he pays back a certain amount monthly with interest to the lender through the broker who had helped him finance his home. In this transaction, Wall Street bankers found a way to make some money. The Wall Street bankers started buying these mortgages in huge quantity and divided them into three packets (safe, medium, risky) to be sold off to investors. This dividing of mortgages into three categories based on the return on investment and riskiness is called Collateralized Mortgage Obligation. So now the borrowers(home owners) are paying their mortgages/debts to lenders who then sell them off to the Wall Street bankers who then sort them out based on the credit rating on these mortgages and finally sell them off to investors. Because the interest rate had been artificially kept low since the Federal Reserve wanted to stimulate the economy after the dot-com bust, lots of investors flocked to the housing market to profit from the higher interest rate. This process of passing through mortgages/debts(from homeowners to lenders to Wall Street bankers to finally investors) is called securitization.
In this structure, all parties benefited at first. From the perspective of the investors, they enjoyed higher return on their investment and the Wall Street bankers could take the commission from investors and also the difference between the price they bought the mortgages from the lenders and the price they charged to the investors. Lenders also benefited since the Wall Street bankers offered them competitive price to buy off their mortgages.
From the perspective of home owners, at first, it seemed like a good deal since they were able to do something called refinancing. Let's say that Tom bought a house that cost $600,000. He paid $200,000 up front and got mortgage for the rest.
And for the past 2 years, he had been paying off his mortgage plus his interest which was set at 3.5%. However, as the value of his house went up, let's say to $650,000, he now has the option to refinance his mortgage. Because his wealth has increased he could technically cash out the difference of $50,000 as debt(also known as the home equity loan) or get a better interest rate for his mortgage since his credit score went up due to the fact that his wealth increased. When refinancing happens, other parties also benefit; the whole process of securitization happens all over again leaving all the middle men richer with commission. (The Flaw, 2010)
sounds like win-win for all? Why did this become a problem?
The problem unfortunately happened when the investors kept clamoring for more mortgages. However, there are only so many people who want to buy houses. So what lenders started doing was issuing mortgages to people with questionable credit history. Thus, we are introduced to the term, subprime mortgage. The Wall Street banks that divided up purchased mortgages into three groups were also at fault as they did not regulate the credit rating with much integrity and continued to profit from selling off dangerous default prone sub-prime mortgages to investors. When these "risky" home owners defaulted one after the other, the whole system, therefore, started to crumble down. To make things worse, the value of the houses started to depreciate. People who had been led to believe that the value of houses would continue to rise were at that point maxing out on their debts through the home equity loans; these people started defaulting as they were no longer eligible for refinancing with their bad credit score due to the decreased value of their houses. So we see over 3.1 million foreclosures in the year 2008. (The Flaw, 2010)
For visualized explanation of the 08' Financial Crisis
So how does neoliberalism factor into this?
At first sight, all these economic jargons and the complexities surrounding the housing market make this connection between neoliberal policies and the 08 subprime mortgage criss hidden from the general public. However, the neoliberal policies of the 70s and onward laid the foundation for this recent economic catastrophe. Here are some examples:
The list goes on. Under the banner of deregulation and elimination of barriers to entry(for certain parties, not all), neoliberal policies helped create a peculiar economy and society that came to encourage people to be more indebted so that banks, lenders, and investors could further increase their profit. And when bad debt piled on top of one another, it was only a matter of time that the whole system collapsed.
- The Depository Institutions Deregulation and Monetary Control Act made it possible for homeowners to borrow money against their houses as collateral (also known as home equity loans).
- Alternative Mortgage Transaction Parity Act of 1982 allowed lenders to lend money with repayment methods that made it possible for borrowers to pay back interest first and principle at the end in lump sum. This led to higher chances of irresponsible borrowers defaulting because they are not encouraged to pay their interest and lump sum little by little over a long period of time.
- Secondary Market Enhancement Act deregulated the mortgage security market so that private mortgage securitization companies could compete with the federal ones.
- Tax Reform Act of 1986 eliminated tax deductions on car and credit card loans while increasing tax deductions on home equity loans. This act encouraged people to take out even more money against their houses
The list goes on. Under the banner of deregulation and elimination of barriers to entry(for certain parties, not all), neoliberal policies helped create a peculiar economy and society that came to encourage people to be more indebted so that banks, lenders, and investors could further increase their profit. And when bad debt piled on top of one another, it was only a matter of time that the whole system collapsed.