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Learning about the Subprime Mortgage Industry

Yuliya Demyanyk as a senior research analyst works for the Federal Reserve in Cleveland. She has documented the rise and fall of the subprime mortgage industry. A subprime mortgage is a mortgage given to a individual whose credit rating is dubious. Often suprime mortgages were adjustable-rate mortgages; that is, the interest rates were not fixed but could increase given the terms of the loans.

This definition of a subprime mortgage is simplistic. Demyanyk pointed out that lenders sometimes labeled a mortgage subprime, even if the borrower had a good credit rating if the loan was unusual such as a fixed rate mortgage changing into an adjustable rate mortgage after a certain number of years. Demyanyk considers this one of many myths about the subprime mortgage industry during the collapse.

The subprime mortgage industry was only 16 percent of all U.S. mortgage debt in 2008. Why then did the suprime mortgage collapse play such a major role in an international financial crisis? Demyanyk states that the complexity of the subprime mortgage industry lent itself to creating leverage problems in the financial institutions. Subprime mortgages were packaged into securities that were repackaged into complex financial instruments called derivatives.

The financial institutions split these derivatives into tranches and sold them to customers such as pension systems. Thje financial institutions became highly leveraged as they bought more and more of these securities to sell them. The credit rating agencies which received fees from the financial institutions helped the boom by rating 80% of these securities as triple AAA. When enough of these mortgages starting defaulting, the securities lost their value and the financial institutions were threatened. They were threatened not only because they had gone into so much debt buying these securities but because of the complexity, no one could figure out what any of the tranches were worth. Hence, the government bailout commenced. Greed makes individuals stupid.

PS. If you would like to read more about Demyanyk’s research, click on the link.

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