Economics, 3rd Edition

SELF TEST 

Why did financial institutions increase lending to the sub-prime market? Was such lending 

always doomed to failure?

earlier chapters, new products which securitized the loans that were being made along with the develop-

ment of credit default swaps (see Chapter 24) to help insure against the risk of default, changed the nature 

of banking as we outlined in Chapter 26.

In the case of sub-prime loans the individual taking out the mortgage clearly has some credit risk by 

definition. Individually such a loan has a credit risk which is likely to be much higher compared to a loan 

made to a corporation. It would be unlikely that the risk for such a debt could be passed on to someone 

else. However, bundling up a collection of such debts makes the proposition somewhat different. Putting 

together a collection of loans and assessing the risk of default was subject to statistical analysis. A propor-

tion of the collection is likely to be subject to default; a mathematician or statistician can provide detailed 

analysis of the extent of the risk involved (which is why such skills are highly valued in financial markets). 

Collectively, therefore, these loans can be offered as a far more attractive proposition to a potential group 

of investors looking to increase their earnings.

The incentives for those involved in banks and other financial institutions were to assume a risk-seek-

ing approach, therefore. The demand by shareholders for better returns, the existence of a bonus culture 

which could provide some individuals with millions each year, the desire by individuals to get on the prop-

erty ladder and, some argue, the lack of rigour in regulation and oversight by the central banks combined 

to provide a situation where the bubble could feed on itself and generate ever greater lending and the 

search for ever more attractive investments.

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788  PART 15  INTERNATIONAL MACROECONOMICS

of  5.2  per cent by September 2008 but the Bank of England had started to increase interest rates in 

June 2006 and a series of quarter-point rises saw Base Rate increase to 5.75 per cent by July 2007. 

In the US, the Fed raised interest rates for 16 consecutive months to June 2006 and the Federal Funds 

Rate reached 5.25 per cent by the autumn of 2006. As interest rates rose, borrowers, especially those 

on sub-prime mortgages, began to feel the pressure and reports of the number of defaults on sub-prime 

loans began to rise.

Once mortgage defaults began to rise to alarming numbers the number of financial institutions 

affected and their exposure became clearer. The whole edifice was based on the expectation that 

the underlying assets would continue to generate the income stream over time – in other words, the 

mortgage holders would continue to pay their monthly mortgage repayments. How did these mortgage 

defaults begin to happen? We have already seen how teaser rates tempted many to take on the burden 

of a mortgage but this was not necessarily accompanied by a full understanding of the financial com-

mitments being undertaken. After the teaser rate period finished the mortgages had to be restructured 

based on a new rate of interest. The new rate of interest not only reflected the need to claw back some 

of the interest not paid in the initial teaser rate period but also the fact that these borrowers were 

higher risk.

As mortgage rates rose, borrowers found it increasingly difficult to meet their monthly payments. In 

some cases the difference between initial monthly payments and restructured payments based on new 

interest rates was significant; many homeowners found their payments more than doubling. The sub-

prime market contained a large number of people who were least able to cope with significant changes in 

monthly payments but in addition those that had taken out sub-prime mortgages for second homes and 

the buy-to-let market also found themselves stretched.

Faced with payments they could not afford, borrowers looked to either sell their property or face the 

prospect of foreclosure – the point where the mortgage lender seizes the property. As the number of fore-

closures increased, house prices fell. As house prices fell, more and more people were caught in negative 

equity. The option of selling the house to get out of the debt was not an option for many; they would still 

be left with a large debt which they had no hope of paying off. The situation was particularly bad in certain 

areas of the US. The house price bubble had been focused on particular areas in Las Vegas, Los Angeles 

and Miami. These were areas that were hit worse by the rise in foreclosures. As the number of foreclos-

ures rose the supply of housing increased and, true to basic economic principles of supply and demand, 

the price of houses fell further.

Note that foreclosure means seizing the property – to get to this stage a number of other routes and 

methods to help recover the debt will have been taken so this really represents the last straw in the pro-

cess. Once foreclosure has occurred then the bank or mortgage lender acquires the property as an asset 

against the loan but then has to incur the cost of managing the property – maintaining it, paying property 

taxes and insurance, for example, as well as the cost of trying to sell it to realize the cash. In times of 

falling house prices the cash realized on the sale may be far less than the original value of the asset. As a 

result banks have to write down the value of their assets.

As the sub-prime market collapsed, the exposure to bad debt started to become more obvious and 

a number of banks reported significant write-downs and losses. Confidence in the banking system, so 

important to its functioning, began to fall. Banks were not sure of their own exposure to these bad debts 

(referred to as toxic debt) and so were also unsure about the extent of other banks exposure. Interbank 

lending began to become much tighter as banks were unwilling to lend to each other and also faced the 

task of trying to shore up their own balance sheets. Interbank lending effectively ground to a halt. (See 

Chapter 26 for an outline of how the process unwound.)

The seizing up of credit markets had an effect around the world. Banks in Iceland failed; in eastern 

Europe the Ukraine applied for a 

$16.5 billion loan from the IMF whilst Hungary looked for $10  billion, 

this after receiving a 

€5 billion loan from the European Central Bank and raising interest rates by 

3 per cent to 11.5 per cent. Turkey, Belarus and Serbia also sought financial assistance as credit dried 

up and banks around the world found they had increasing difficulties in meeting their liabilities. Belarus 

looked for a 

$2 billion loan from the IMF and Hungary. In the Ukraine, the currency, the hryvnia, fell by 

20 per cent and around 80 per cent was wiped off stock market values. The Ukraine central bank was 

forced to use reserves to try to buy hryvnia in an effort to support the currency. The Russian stock 

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CHAPTER 37  THE FINANCIAL CRISIS AND SOVEREIGN DEBT  789

market fell by around 66 per cent between May and October 2008. Put simply, most of these banks 

had lent too much money, had been exposed to the debts related to purchases of CDS and could not 

meet payments which were falling due. Without financial assistance these institutions could have col-

lapsed and financial systems in these and associated countries were grinding to a halt.