Simple Way to Explain Subprime Crisis

Have you heard about subprime crisis in U.S? Do you know what is it? Do you know why it happens? This article provides a very simple explanation of subprime crisis especially for those non-financial people or economist.

It was a very hot issue that has been discussed over the last year. I tried to search around the web to get more information about this subprime crisis in U.S. but all those explanations were too difficult for me to understand. So, this article is to simplify the explanation of subprime crisis which appears to be a very complex thing. I did this on my own research based on my understanding. You can verify whether my understanding is correct or not.


What is Subprime Mortgage?

First of all, we need to understand what subprime means. By dictionary, “Subprime” is an adjective relating to or for people with a poor credit rating. Simply says, if you never clear your credit card balance monthly, you have a poor credit rating. A poor credit rating people are disqualified to apply for conventional mortgage or loan application. They’re disqualified because they have higher risks that they are not able to make the loan payment due to their poor credit history. Bank is very clever. They come out a special type of loan to these poor credit rating people. This loan or mortgage is called “Subprime Mortgage” or “Subprime Loan”.


Why Banks Want Subprime Mortgage?

Why banks (subprime lenders) want to lend money to those who have bad credit history? They may not even able to payback the bank. But still, why they want to do that? Yes, you got it. It is all related to money. The banks are also greedy and they want to earn more. The main reason why the banks want to do this is they predict the value of the property will be going up. So they increase the mortgage interest rate (higher than the conventional loan) and they call it a subprime mortgage. They earn more with the higher mortgage interest rate and just in case the borrowers can’t continue the payment, they still can sell the houses with higher value due to the property appreciation.

To further reduce the risks and to get more loans (earn more money by loan interest), the banks repackage all mortgages into an investment product and sell it to financial institutions in all over the world (not just in U.S). This is now not only between banks and borrowers get involved in this subprime mortgage but also all the financial institutions around the world. You may ask why they want to invest in this high risk product (pool of subprime mortgage)? One reason, they believe that the property value will go up.


What happen to subprime borrowers?

They buy the house only for one reason which is expecting value of the houses to go up and they earn from the property appreciation. They can rent out their house with higher value or they can sell the house with higher value. All the debts they had previously can be easily paid off. Because house prices had increased so rapidly in the past few years, paying back the loan payment is not a problem at all. The borrowers also refinance their loan at more favourable terms due to they no longer have a bad credit rating history.

Can you see that? Everybody wins! Borrowers, banks and financial institutions are eating the same cheese happily and the cheese is “property appreciation”. Yummy, yummy!

When and Why Crisis Happens?

I think you should be able to guess it by now when the crisis will happen. Everybody enjoys the same cheese, if the cheese is gone, what happen? Crisis happens. It is that simple. When the house or property values drops, the cheese is gone. Everybody wins now becomes everybody loses!

When demand is more than supply (everyone wants to buy house), the property values went up like crazy. Until one day, when it becomes much more expensive to borrow, less people could afford to buy a house. As there were not as many buyers, the real estate market begin to cool down and house prices begin to fall.

When the house prices begin to fall, the subprime borrowers are going to suffer. Not only they’re not able to pay their existing debt, they are stuck having to pay a much larger mortgage payment. This causes many of these borrowers to not be able to make their house payment.

So for the financial institutions, they are going to lose their money that they invested because the borrower are not able to pay the loan payment. On the other hand, banks have a very big problem also because they rely on this these financial institutions to invest in the pool of mortgages investment product. Financial institutions no longer wants to invest and do not trust the bank anymore. If no wants want to buy them, where the banks get the money to offer the loans?

They bank also suffer from the lost for those borrowers who failed to make payment. As a result, the banks increase the mortgage interest rate to cover loses and hopes that borrowers (who afford to pay) can pay more. Sadly, the effect is opposite and this even makes the conditions worst. More and more borrowers failed to pay their monthly loan payment due to the interest rate increases. Crisis happens! Everyone suffers!

Conclusion

Subprime crisis happens because everyone predicts the property value will appreciate over time. The economy now is no longer as simple as in 30 years ago where we can predict the future with certain of accuracy. Future is getting harder and harder to be predicted for the coming years. What it next? It is really unknown.

Therefore the impact of this crisis is still has a lot of uncertainty. Will it causes another economy recession in U.S since 2000? Will this affect other countries? This is another huge topic to be discussed. Anyway, I hope this post is making sense and give you a little bit general idea on this subprime mortgage crisis in U.S.

[Updated - 20 Jan 2008]
Check out the latest news of the effect of the subprime crisis - Citigroup loses almost $10B

To have more comprehensive of explanation (which I find it difficult to understand), you can refer to this article from wikipedia.

[Updated - 2 Feb 2010]
P/S: I recently wrote about Understand Money as Debt Concept topic which could be one of root causes of this subprime crisis. You may want to read the article. Let me know if that is useful as it could be quite difficult to understand.