To say that the economy is going through a crisis at the moment would be a massive understatement. The source of this crisis has been essential a system of bad debt which has eventually imploded. The name of the crisis is the Subprime Mortgage crisis and in understanding it better we can really see the full scale of what has been going on.
Naturally however this is a complex issue so we are going to try and break it down and explain exactly how this happened and why.
Let’s take a look at an example of how these mortgages were packaged in order to gain a fuller understanding of where things went wrong.
Say $100 is given as loan to Mr. A at 12% interest. Then the loan company cannot further use $100 as it as already given it to Mr. A. So, it announces that it selling a bond of $100 at the rate of 10% interest (thereby making $2 on every home sold). This way the loan company gets another $100 to give to Mr. B(yet another homeowner) and his profits go on increasing. But this seemed a very risky proposition from the starting — so they employed companies which were known as guaranteers in case the money was not received back from Mr.A(the homeowner) and Mr. B . These companies were Bear Sterns, Citigroup, Merrill Lynch, and many more [about a 100 odd] including Indian ones like ICICI Bank.
As you can see there was already rocky foundations underneath this house of debt.
In an effort to sell more products, banks and lenders encouraged home owners to buy land with relatively no downpayment and a very attractive repayment scheme. Naturally this encouraged a great deal of people to invest in mortgages, and thus they bought more properties and land. What this did was bring in people to get mortgages that they could not in fact afford, and after not too long people started to default on those mortgages. This resulted in the loan companies being liable to pay investors on the bonds they had sold and the impact was massive based on the fact that the guarantors of the loans were the big boys in finance.
As a fall out of this crisis we have seen over 100 mortgage companies close its doors, record losses posted by the likes of Bears Stern and Merrill Lynch, homeowners across the country negatively impacted and a massive surplus of properties. Naturally the government have had to step in to save banks and to try and secure new debt from the banks moving forward, which is critical to the recovery of the economy. This too will have a knock on effect to the tax payer.
These loans that were packaged unsafely and sold as safe were always going to default, and the handful who are responsible may never be found out for their malpractice.