Readers Question: The money that brokers/banks etc were making from selling on the mortgages to investors encouraged the sub prime debacle. Which I understand. The bit I am struggling with is what started the fall in the US housing market. If the banks slowed down on their lending that would surely just cause a slow down in new mortgages which would result in a slow down in the housing market.
It was in the US housing market that the real problems emerged. It was mortgage defaults that caused the biggest hole in bank balance sheets.
In the boom period, mortgage lending had been very aggressive. Mortgage companies made new mortgages to
- People with bad credit,
- Mortgages with high income multiples,
- Mortgages with low introductory offers – low interest rates for first year, then rising interest rates.
Basically, people were being given mortgages, who in ordinary circumstances wouldn’t be able to afford their mortgage payments. A fundamental problem was the lack of satisfactory regulation in the mortgage market. It was kind of hoped US housing prices would keep rising so that if people couldn’t afford mortgage payments the house could just be sold.
However, when US interest rates rose in 2005 and 2006, many US homeowners started to default on their mortgage payments, and homes began to be repossessed; as a result banks lost money. Mortgage defaults also spread across the financial system because these mortgage debts has been repackaged (sold on) to other banks.
This is when the credit crunch really started to occur, banks balance sheets were adversely affected by mortgage defaults of US homeowners. Because banks and other financial institutions lost money, they also had to cut back on lending. This led to fewer people buying houses and caused an even bigger drop in house prices. As house prices fell, banks lost more money on mortgage defaults.
See also: Boom and bust in US housing market
Is it the case that the money the banks borrowed came from Asian investors via the money markets?
I’m not exactly sure about the source of funds for money markets, it would have come from a variety of sources. During 200s, there were significant inflows from China (mostly into US treasuries). The inflow of money into US did mean interest rates on assets were low and there was greater search for yield; this search for a better return, arguably, encouraged more risky lending practises.. But, inflows from Asia were not the root cause of the crisis; they only perhaps slightly magnified the housing boom.
Also if I am correct I understand that the “reserve ratio” is changed from time to time by the Government and if I remember correctly a few years before the mortgage boom the “reserve ratio” was reduced for the big investment banks in the US which allowed them to hold less of a percentage in their “reserve ratio” at the central bank.
I’m not sure of the details, but the process of financial liberalisation during 1980s and 1990s reduced reserve ratio requirements for banks and financial institutions. Thus, in the years leading up to the credit crunch, banks were free to lend as much as they liked.
- Credit crunch explained – I wrote this article for another blog but is a good summar