Subprime Mortgage Crisis

Subprime Mortgages are loans made to people with a less-than-spotless credit history (see Wikipedia for a summary, or this BBC summary). Traditionally, if you had made some mistakes in the past with your finances, banks would only lend you money if you agreed to pay a higher rate of interest to reflect the increased risk. Often they would not lend anything, hence creating a perfect breeding ground for loan sharks who capitalised upon this.

As the model of securitisation developed, Banks and other financial institutions were able to more effectively spread the risk involved in doing subprime business, which therefore became more attractive to them. In a rising property market (e.g., in the US) the potential reward in offering subprime mortgages becomes more and more attractive, to the extent that emotional factors can start to blind people to downside risks. In other words, people start thinking "everybody else is making a mint out of subprime mortgages in this housing market - I want a piece of that action." This is an example of "mispricing of risk."

In the US in 2006, interest rates started to rise, and the housing market slowed down. The effect of this was to increase the rate of mortgage default by people with subprime mortgages (unsurprisingly, you may say). In an effectively operating financial system, this would not be a problem, because it would have simply been a realisation of a known risk that had already been factored into the system. However, in this case, risk had not been effectively priced in. On the contrary, it had been understated. This triggered the unfolding of the subprime mortgage crisis.

Lack of Transparency leads to Liquidity Freeze and the Credit Crunch

Figure 3 is taken from a useful Bank of England presentation on the crisis. It shows how the Subprime Mortgage Crisis had knock-on effects throughout the financial system.

Figure 3 - The Phases of the Crisis, courtesy of Bank of England

The final phases of the crisis in this diagram, shows a drying-up of liquidity in the market - this is what is referred to as the credit crunch. Further on in the BoE presentation is a graph which shows the LIBOR (London InterBank Offered Rate - the rate at which banks lend money to one another) spreads over the comparable central bank rates (below - UK rates in Blue)

Figure 4 - 3-month LIBOR spreads over policy rates, courtesy of Bank of England

Put simply, during mid-August Banks suddenly realised that the Subprime Mortgage Crisis was quite serious, and that various institutions were losing a significant amount of money over it. The problem was, they did not know who! The market was not transparent enough. Bank A looked to Bank B and thought, "hold on, are they about to be affected by this? If so, it is going to be very risky lending them money, so I will charge them more." Furthermore, Bank A was also looking inwards, and wondering how much trouble it was in, itself! Not really knowing, it started to hoard its own cash. This explains the rocketing of LIBOR rates over central bank rates - from around 10 basis points to over 100 basis points.

For more reading on the reasons behind the credit crunch and the role of transparency in it, you can refer to a useful Financial Times online debate in which I recently participated.