What it means
In the years before the crisis, lenders in the United States made large numbers of mortgages to borrowers with weak credit, often on terms that depended on rising house prices. Many loans carried low introductory rates that later reset higher, and some were approved with little proof of income.
Those mortgages were bundled into securities and sold to investors around the world. The packaging spread the risk but also hid it, because buyers often relied on credit ratings and had little view of the individual loans behind them.
When house prices stopped rising and then fell, borrowers could no longer refinance or sell for more than they owed. Defaults climbed, the securities lost value, and banks and funds that held them reported large losses.
Lenders also grew wary of lending to one another because nobody could tell who was holding the damaged assets. The result was a squeeze on credit that reached businesses and households far removed from subprime lending.
Firms found it hard to borrow, several large financial institutions failed or needed rescue, and many economies went into recession. Ordinary households felt it through falling home values, lost jobs and tighter lending.
Unemployment rose, spending dropped, and many people owed more on their homes than the homes were worth. The episode changed the rules.
Regulators in many countries introduced stronger requirements on checking a borrower's ability to repay, on the capital banks must hold and on how much risk issuers must keep in the securities they sell. For managers, it remains a lasting lesson on how quickly risk spreads when many parties rely on the same assumption.
In practice
Real-world examples.
Example
A regional bank holds securities backed by subprime mortgages and sees their market price fall by 30% in a few months. It must record the loss, which reduces its capital and limits how much it can lend to local businesses. The bank's board orders a review of every similar holding and asks the finance team to run a downside scenario for the next two years.
Example
A manufacturer relies on a revolving credit line that its bank suddenly refuses to renew because the bank is conserving cash. The company has to delay a planned expansion and draw down its own reserves. The finance director also begins talks with a second lender so that the business no longer depends on one bank.
Example
A pension fund discovers that a highly rated bond in its portfolio is backed by weak mortgages. The investment committee changes its policy so that it examines the loans behind any securitised product before buying.
Formula
Calculation
The loss on a pool of mortgages can be estimated with:
Pool loss = Pool balance x Default rate x (1 - Recovery rate)
Take an illustrative pool of $1,000,000,000 of subprime mortgages. If 15% default and the lender recovers 55% of the balance by selling the houses, the pool loss is $1,000,000,000 x 0.15 x (1 - 0.55) = $1,000,000,000 x 0.15 x 0.45 = $67,500,000. If the lowest-ranking slice of the securities is $50,000,000, it is wiped out and the next slice up absorbs the remaining $17,500,000.Case study
Seen in the real world.
Oakmont Capital is an illustrative, fictional investment firm that bought mortgage-backed securities in the mid-2000s because they paid a little more than government bonds and carried top credit ratings. The managers believed that house prices in a broad national market would not fall together.
When local property markets weakened at the same time, the delinquency rate on the underlying loans climbed from 5% to 20% within eighteen months. The securities lost most of their value, and Oakmont's lenders demanded extra collateral that the firm could not provide.
In this illustrative story, the firm closed within the year. The partners later said their central error was treating a rating as a substitute for understanding the loans, and they would now ask what happens if house prices fall everywhere at once. They also said they should have limited how much of the fund sat in a single type of asset.
Watch out
Common mistakes.
- Believing the crisis was caused only by borrowers, when lenders, investors, rating agencies and regulators all played a part.
- Assuming that packaging loans into securities removes the risk, when it only moves and spreads it.
- Treating a strong credit rating as proof of safety without checking the quality of the loans behind it.
Questions
People also ask.
When did the subprime meltdown start?
Problems appeared in 2007 as defaults rose and it deepened into a wider crisis in 2008.
Why did it affect people who never had a subprime loan?
Banks lost money and cut lending, so businesses and households faced tighter credit and a weaker economy.
Could it happen again?
Rules are stronger now, but similar problems can arise whenever lending standards slip and many parties share the same risky assumption.
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