| Subprime crisis |
In 2006, Nobel laureate Paul Krugman wrote that “Nowadays, we make money by two means- by borrowing from China, and by selling houses to each other.”
He was pointing to the bubble that was fast building up in the housing market, which, he said, the Fed, under Alan Greenspan, had created to replace the Internet bubble that had burst earlier. Americans did really want houses, but in there were others, who saw a quick way to make money on the back of this demand. They bought houses as investment, confident that they would be able to sell them at a higher price later.
This continued until house prices had become irrationally high. People were buying houses at exorbitant prices on the belief that they would be able to sell them off. Banks were lending money to those with bad credit records, to those whose incomes were insufficient to pay off the housing loans on the same belief. These borrowers were ‘subprime’ borrowers. That is, borrowers not qualified for the loans that they were getting.
Next, the banks themselves sold off the debt to other financial institutions after splitting them into small pieces and combining them with slivers of other financial products. This was supposed to mitigate risks by spreading them around.
The secondary agencies that brought these ‘packages’ further slashed them into small slices and combined them with their other offerings to make new packages, creating a financial instrument of extreme complexity. Nobody really knew how to evaluate the risks on these products.
These bonds were then insured in the derivatives market. For example, if an agency has a bond which will give it $10 mn at the end of 10 years, it would insure it with another agency which would pay the entire $10 in case the bond does not deliver, in exchange of a certain share of its annual return. This was the derivatives market.
On the other hand the public that had taken loans to buy houses (a certain section anyhow), mortgaged them for immediate money. The mortgages were split and sold by primary agencies in the manner explained above.
So when house prices started their fall, all of the above bonds went bad. The losses were so widely spread that no one knew who really had how much of debt.
The banks which held the mortgages of these houses could not recover their money even by foreclosing. The type of spiral that had caused the prices to rise abnormally, now acted downwards. People anxious to recover as much of their investment as possible in a falling house market started panic selling, leading to a glut of houses in the market, which further pushed down prices.
This sudden collapse in the housing market had wide ranging effects.
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