Subprime Mortgages and the Causes of the Economic Crisis

Introduction: Understanding the Crisis

The complex interactions and relationships that make up the global economy make it very difficult to describe the causes of any large-scale economic event in a manner that is at once accurate and succinct. The recent economic crisis is no exception; the global recession was caused by a confluence of forces and specific aspects of the relationships that exist between various economic entities and nations. At the same time, there is one element that can be cited as a substantial cause of weakening and even eliminating certain major financial institutions, shaking up the financial industry as a whole, and thus triggering other events that contributed to the recession.

This one element can be summed up in a phrase familiar to anyone who paid even the slightest attention to the news in the preceding years, yet its role in the financial crisis is still not entirely understood by many and seems clouded in mystery. In reality, subprime mortgages and the problems they led to are relatively easy to understand, though it is difficult to comprehend how these problems were allowed to develop as far as they did.

What Are Subprime Mortgages?

A prime loan such as a mortgage is one that is given to someone who is highly creditworthy — that is, there is a low risk of default and a high likelihood that the loan will be repaid and investments recouped with interest. Subprime simply means "below prime" or "less than prime," so a subprime mortgage is quite simply a home loan made to a risky borrower. Private lenders like Countrywide and semi-public entities such as Fannie Mae and Freddie Mac made many of these subprime loans in the decade leading up to the economic crisis, which created inflated home prices but also generated high expectations for money that ultimately was not going to be repaid.

Risky Lending Practices and Fraud

Many subprime mortgages were made with little documentation of income or ability to repay, or other elements that typically safeguard loans of all types and mortgages especially. There have even been cases of widespread fraud, where documents were falsified in order to approve loans. The reason many lenders were so eager to make these bad loans is that they were not ultimately going to be responsible for them — the loans were bundled into groups and sold as mortgage-backed securities, so instead of dealing with many individual loans worth an average of a few hundred thousand dollars, banks and other institutions were dealing with bundled groups of these bad loans worth millions of dollars apiece.