The major contributing factors of the subprime mortgage crisis in the U.S. were mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). Subprime MBS and CDOs attracted lots of investors into investing in it due to the higher interest rates offered on their mortgages as opposed to the assets backed by the prime mortgages. The borrowers who used the subprime mortgage and had less than perfect credit, they had higher rates on their mortgage because they had to face more considerable loss with an increased risk. Furthermore, many loans which were adjustable mortgages in case of rates were introduced later that added additional fuel to the existing crisis.
Around this time, lenders got together and put together the subprime mortgages into MBS and CDOs. These products that they pooled financially received excellent ratings from credit agencies. Tranches of these were sold off illegally to investors who were unsuspecting of anything wrong and who were not aware of the enormous risk that would go along with it. The tranches that were lower in quality did offer higher interest rates but ultimately absorbed the first losses that were resulted from defaulting mortgages before the senior tranches.
What happened next?
The subprime crisis was the cause of a dramatically huge increase in mortgage credit. Many loans were given to borrowers who would have previously had difficulty gaining mortgages because of then having below-average credit scores. Private lenders took the opportunity to make a lot of money by pooling in and selling these mortgages.
But with the relaxing of credit standards, the risk of foreclosure increased considerably. Lenders and buyers assumed the wrong values of real estate and were unknown to the downturn. MBS that were privately labeled provided a lot of necessary capital for the mortgages that were subprime. A roundup of 80% of subprime loans was carried out with private label MBS in the year 2006.
In the next year, March, subprime mortgage’s’ value was summed up to be approximately $1.3 trillion. The mortgages that were issued by private lenders had a higher risk of loss since they did not have the government backing them up, like Freddie Mac and Fannie Mae.
In the end, only when there was a decline in the property values, did the severe issues begin to appear. There was a whopping increase in the adjustable rate mortgages, and illegal mortgage grew suspiciously high. More problems arose due to defaults on subprime mortgages. By the time August came in the year 2008, approximately 9% of all mortgages in the U.S. were suffering from default. MBS and CDOs had begun to face a lowering of value with the higher default rates.
The government had seized Freddie Mac and Fannie Mae in 2008 since they had started to meet a large number of losses. As banks tried to liquidate their funds, foreclosures and repossessions increased, especially with more properties that were being put on the market.