The Sub Prime Crisis

The Sub Prime Crisis

Countless words have been written and certainly will be written about the “real estate crisis in the United States” or the “economic crisis of 2008.” This is not surprising, as this is an event that began to roll in the United States and created a crisis that threatened the existence of both American and the global economy.

What had actually happened?

It all started with the high-tech boom that created many funds available for investment in the early 2000s. The increase in available money, relatively low interest rates and favorable legislation by the US administration created a situation in which buyers were not required to provide a down payment for the purchasing of an apartment or a house. In addition, the rules by which buyers of real estate were pre-approved when purchasing an apartment, their flexibility and their income and repayment ability were significantly eased – people who didn’t consider real estate with low repayment ability, entered the market. They were able to buy real estate without initial capital, by repaying monthly payments only. In fact, a situation was created in which there was no risk of purchasing an apartment or property because no down payment was required and thus the purchase of the property became similar to a lease or rent. In case of inability to repay the mortgage, no damage was caused to the buyer. The bank repossessed the house and sold it at the open market.

The real estate bubble began to emerge

These conditions created a boom in the American real estate market, and the administration relaxed mortgage and financing conditions, allowed many people to join the real estate market. This in turn created a rise in asset prices and turned real estate to a major investment channel – the acquisition of assets was perceived as a less risky investment than the purchase of shares and more profitable than bank deposits and the purchase of bonds.

The US real estate market was fueled by cheap money that financed real estate. The ease of getting financing was one of the main factors that have created the subprime crisis – that is, providing credit to customers who were not high-quality customers and likely to default.

The value of US real estate market and the value of the stock market of credit and real estate companies grew out of proportions. In addition, the market has started to offer various mortgage-based financial instruments – mortgage-backed securities (MBS) and the notorious Collateralized Debt Obligation (CDO). Essentially, these two financial instruments enabled the purchase of bonds and bundles of debts packaged as a high rated financial product with some value similar to the share. The way it operated was as follows – the bank had a lot of borrowers who took mortgages. They have paid money on a monthly basis. Therefore, this revenue stream could be considered as a monthly profit. Since the real estate market grew, and because number of mortgages increased, the value of the bond backed by these mortgages and the value of the CDO in which these debts were packaged increased.

The base assumptions that brought down the house of cards

All these financial acrobatics was based on a number of assumptions – people will continue to pay mortgages, the real estate market will continue to grow, and interest will not rise.

The lack of supervision of financial instruments prompted banks and investment companies to generate derivatives on the basis of bonds and CDO products. Thus, financial instruments were created for trading based on the collection of several bonds and the number of CDO products. Along with tempting credit ratings, a huge market has been created for products whose level of risk was enormous but not visible to investors. Investment bodies leveraged themselves without limits, regardless of their self-worth.

At the end of 2007 and the beginning of 2008, conditions in the United States deteriorated. The economic situation worsened, the interest rate rose, and the number of people who stopped paying mortgages increased significantly while the value of assets began to fall. The banks that provided the loans got stuck with houses whose value had declined and no one wanted to buy them.

The Great Crash

Domino stones began to fall because the value of shares of bankers and investment houses were closely related to the real estate market (perceived as a market that is constantly rising …) In addition, financial instruments based on mortgages (MBS and CDO) have lost their value – as you remember, these were actually packaging of debts and mortgages.

The collapse of hedge funds in the summer of 2007 prompted the US Federal Reserve to lower interest rates to cool the market, but that did not help. The economic crisis began in 2008 when there was a genuine fear that the banks would be unable to finance the current economic activity of the market. The US administration intervened and poured in a lot of money to stabilize the system. During the crisis, 12 financial institutions and banks were closed in the United States and many banks in the world were exposed to the US real estate market, suffered economic slowdown and significant losses. In Iceland, for example, collapsed all banks and the country was facing bankruptcy and incapacity of economic functioning. Fortunately, a conservative approach of the Bank of Israel, which prohibited financial institutions in Israel from making investments in the real estate or real estate-backed products markets, and as a result of the lack of investment ability of Israeli financial institutions abroad, the economic crisis passed on Israel and did not cause casualties in the financial market.

The world is recovering from this crisis to this day. Huge losses were recorded for pension funds, investment companies and countries around the world.

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