Why The Sub Prime Crisis happened

The sub-prime sector refers to those borrowers who have a history of bad credit. This may range from a simple late payment, to several defaults and even bankruptcy.

In America the sub prime sector gained a bad reputation because many mortgage lending companies sold mortgages to people, even though the mortgages were often inappropriate. The problem was that mortgage salesman were getting commissions for selling products; therefore, they frequently sought to ignore issues of low affordability.

Many sub prime mortgages were targeted at first generation immigrants on low paying jobs. Another feature of sub prime mortgages in the US was that they often had very attractive initial periods of repayments. – For the first 2 years the interest rate was low, but, then it reverted to a much higher rate and people were tied in. But, at this rate they couldn’t really afford. – This is one factor that led to an increase in mortgage defaults.

With a small rise in US interest rates, many found they could no longer afford the repayments, especially those who had just come to the end of their introductory period.

With the rise in mortgage defaults, many of the leading sub – prime mortgage lenders went bankrupt.

The sub prime mortgage lenders usually sold most of there mortgage debt onto other banks. – This enabled them to raise money to fund more sub-prime mortgages. This is where many big banks have got burnt. Because the sub prime mortgage industry went bankrupt, the banks had to write off their losses. Banks are now much more cautious about buying this debt. After these bad experiences it has become much more difficult for banks and mortgage companies to sell their bundled mortgage debt. – Especially if it is sub-prime.

This is where Northern Rock experienced many problems. They relied on being able to sell these mortgage debt bundles in the financial markets. (Most other UK Mortgage lenders raise more cash through attracting deposits)

However, because of the crisis banks became unwilling to buy their mortgage debt. This left the Northern Rock with  a temporary cash flow situation and is why they had to borrow emergency funds from the Bank of England.

• What we can learn from the Sub Prime Crisis