Mortgage: Meaning and Subprime Mortgage Crisis | Economics Word
Mortgage and Mortgage-Backed Securities: Meaning and Subprime Mortgage Crisis in the United States
Mortgage and Motgage-Backed Securities(MBS)
What is a Mortgage?
A mortgage originates from the French words "Mort" (death) and "Gage" (pledge), but it refers to obtaining a loan by using real estate as collateral. In other words, a mortgage is a loan secured by real estate. During the repayment period, the borrower pays interest and principal monthly, while the real estate serves as collateral. While home mortgages are the most common type, mortgages on commercial real estate also exist. The mortgages that led to the subprime mortgage crisis were primarily home mortgages.
In the United States, mortgages were initially created to assist the working class during the Great Depression, enabling them to obtain long-term loans secured by real estate, making it easier for them to own homes. Even in the worst-case scenario where the borrower couldn't repay the loan, the real estate serving as collateral could be foreclosed to settle the debt.
What are Mortgage-Backed Securities (MBS)?
The problem arises for banks because they can only receive small amounts of interest over a long period from large loans issued for purchasing homes. During this time, the bank's cash becomes tied up in the loan until both the principal and interest are collected over the long term.
To address this, banks devised Mortgage-Backed Securities (MBS), which involve banks issuing bonds secured by mortgages. By selling these bonds to other banks or institutions, banks can immediately collect both the principal and interest, albeit at a slightly reduced rate. With the money collected, banks can issue new mortgage loans and sell those mortgage bonds again.
- In simpler terms, if Bank A with a capital of 1 billion won issues a mortgage loan of 100 million won to Person A, with an interest of 20 million won over 30 years, the bank can sell the mortgage bonds to another entity for 110 million won. This enables the bank to hold 1.1 billion won in capital and issue mortgage loans to 11 more individuals.
The Subprime Mortgage Crisis in the United States
Background and Causes:
In the early 2000s, the outlook for the U.S. real estate market was very optimistic, as property prices were rising rapidly. Consequently, if a borrower defaulted on their mortgage loan, the bank could profit by selling the collateralized property. In other words, rising property prices were outpacing interest rates.
In such circumstances, banks indiscriminately issued mortgages to subprime borrowers (those with a high risk of default), and derivative products such as Collateralized Debt Obligations (CDOs) based on mortgages became abundant.
The backdrop included the low-interest-rate policy of the U.S. Federal Reserve and the U.S. government's policy of one household, one home. Between 2002 and 2006, the U.S. saw a 50% increase in home prices, seemingly without any problems.
Progression of the Subprime Mortgage Crisis:
To sustain the housing price bubble, U.S. property prices needed to maintain a growth rate higher than the interest rate. Therefore, to maintain this situation, it was necessary for U.S. property prices to continue to rise.
The critical point here is that in the U.S., a mortgage ends when the property is disposed of. That is, if property prices are higher than the interest rate, the lender can profit by acquiring the collateralized property if the loan cannot be repaid. However, what about the opposite case? The debtor may have their debt forgiven, but the creditor suffers losses.
As U.S. property prices faltered and delinquency rates surged nationwide, a catastrophe began. Banks that issued mortgages failed to properly collect loan payments. Both MBS and CDOs, which were fundamentally based on mortgages, collapsed as the foundation, mortgages, began to falter. With delinquencies skyrocketing nationwide, the investment capital poured into the U.S. real estate market rapidly evaporated, causing property prices to plummet. With no new loans being issued, a vicious cycle ensued, and the domino effect triggered a global recession.
Aftermath of the Subprime Mortgage Crisis:
The bankruptcy of Lehman Brothers, which held numerous CDOs, dealt a significant blow to the U.S. economy, affecting many countries' economies and initiating a global recession.
In the United States, the subprime mortgage crisis led to events akin to the Asian Financial Crisis, such as IMF intervention. Many middle-class Americans lost their homes and jobs almost overnight, to the extent that warehousing became the most thriving industry at the time.
Furthermore, perceptions among Americans changed, with stable government jobs becoming preferred over previously coveted positions. The subprime mortgage crisis brought about significant changes throughout American society.
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