Written by Antony Fitzsimmons
14th July 2020
Reading time: 4 minutes
A brief overview of the subprime mortgage crisis and how it triggered the financial crisis. See end of article for some useful definitions!
“The largest financial shock since the Great Depression.” That is how the International Monetary Fund described America’s subprime mortgage crisis; a primary cause of the 2007-08 financial crisis. It began as a result of the Federal Reserve cutting interest rates to help stimulate the US economy that was bruised by a mild recession in the early 2000s and the September 11 attacks. The tragedies caused the US economy to lose 0.5% of real GDP growth in 2001, and experience an immediate increase in unemployment. US interest rates dropped from 6.5% in May 2000 to 1.75% in December 2001, as the mania for home ownership grew for several years. Various lenders saw this as an opportunity they could capitalise on, abandoning stringent lending procedures to allow subprime borrowers the guarantee of a mortgage. The word ‘subprime’ is used to simply describe borrowers, with a poor credit history, who have a higher chance of defaulting on their loans.
This was the result of the financial deregulation that had gradually taken place within America, originating in the late 1970s. It encouraged the securitisation of subprime mortgages, enabling them to be purchased by third-party investors in financial markets. With the subprime mortgage market becoming more complex, traditional procedures were abandoned and inadequate evaluation prevailed. Credit rating agencies are widely perceived to have contributed to this by assigning misleading credit ratings to subprime mortgages.
Between 2003 and 2005, Mayer et al (2008) report that the number of subprime mortgages issued almost doubled from 1.1 million to 1.9 million. This inevitably saturated the housing market at a time where interest rates began to rise at an unprecedented rate, leaving many borrowers unable to repay their debts (the vast majority adjusted in-line with the interest rate). Consequently, the US housing bubble burst, house prices began to crash, subprime lenders began filing for bankruptcy and banks became distrustful of each other. The financial loss of this is estimated to be $500 billion. The crisis inevitably bled into other financial markets, causing a deep and long-lasting recession that rippled throughout the world economy.
One country’s economy which was immensely affected by the financial crisis was the United Kingdom’s. A similar scenario was experienced by the UK in which real house prices fell as interest rates soared.
The crisis itself saw the nationalisation of Northern Rock in 2008 – a UK retail bank which gained success in providing subprime mortgages. This was the first sign that Britain was succumbing to the subprime mortgage crisis. Soon after, the US investment bank, Lehman Brothers, filed for bankruptcy, affecting the entirety of the UK’s banking sector which was already declining at an unprecedented rate. The British government, therefore, injected £37 billion into the sector, leading to the partial nationalisation of three UK banks. Then Prime Minister, Gordon Brown, reinforced the bailout by proclaiming the state had a duty to “be the rock of stability” and act to prevent the systematic failure of the UK’s banking system.
The impact of the events highlighted above was historic. Firstly, it led to the crash of the UK’s banking sector, turning the sector’s initial value into a fraction of its former self in the space of two years. This led to the deterioration of the FTSE 100 which suffered its worst-ever annual decrease, plummeting by 31.3% in 2008. The financial crisis also took a toll on the UK’s economic growth. The UK sustained negative GDP growth rates for an entire year, reaching its lowest point of -2.2% in 2008Q4 (ONS, 2020). This is illustrated by a fall of roughly £27 billion in the UK’s GDP between 2008Q1 and 2009Q2 (ONS, 2020).
The crisis clearly inflicted pain on both the UK’s economy and financial markets, however, signs of recovery are apparent. For instance, growth in Britain between 2012 – 2014 outpaced all other members of the G7 (OBR, 2014). The UK’s decision to leave the EU caused the UK’s economic growth forecasts to be downgraded; however, such revisions are dwarfed by the economic disruption caused by the ongoing coronavirus pandemic which is estimated to be far worse.
The International Monetary Fund (IMF) is a global organisation which aims to uphold the stability of the international monetary system.
The Federal Reserve is the central banking system of the United States. Central banks are responsible for controlling inflation and the supply of money in the economy.
Securitisation is when financial assets are pooled and packaged into one group and sold to third party investors. This was carried out to make subprime mortgages appear less risky.
A financial bubble is created when the price of something increases at an extremely fast rate, generally due to speculative demand. Once popped, prices decline at an unprecedented rate causing the market to crash.
The FTSE 100 refers to the one hundred UK companies listed on the London Stock Exchange which have the highest market capitalisation (the value of a company’s combined shares).
Office for Budget Responsibility
Office for National Statistics
Further references are available on request.