Could The Credit Crunch Have Been Avoided?

One of the biggest questions being asked in America at the moment relates the fall out of the sub-prime lending market. Mortgage providers in the States have sold products to people who were in receipt of lower incomes.

This was no problem while the economy was buoyant but changes in the financial markets led to interest rates being put up, which in turn made it increasing difficult for these people to meet the higher repayment charges. This resulted in an ongoing series of mortgage defaults followed by the foreclosure on hundreds of properties. Suddenly the banks, who want to stem the loss, started to reconsider who they were lending to and what financial products they were happy to lend. Less people were then able to get credit and remortgage which led to a credit crunch which quickly spread across the globe.

The question being asked is why was this all allowed to happen. When it became clear that people were unable to afford their mortgages why did the banks not reduce their rates. Why continually increase the repayments for people who the lenders know could not afford it? Surely it would have been better to keep the rates low and the money coming in, than increase the rates and risk non-payment. Banks are showing loses billions of dollars due to foreclosures, it is hard to think that it would not be cheaper for them to try and avoid the situation with lower rates.

The answer to this question is complex. While it seems like a simple solution could have been found that would have kept everyone happy, it is unfortunately not that simple. Even though interest rates were increasing, mortgage lenders could not keep them low for the sub-prime market, because for most of them, it wasn’t their money that they were lending.

The process in America is that banks ask all potential customers to qualify for a loan. Once a number of customers had passed the test, their loans would be buddled together and shown to a number of investors. The investors would then agree to buy that portfolio based on the predicted return that they would be getting. This process is known as securitisation and means that the mortgage lender does not actually own the money it lends out but has effectively sold the mortgages to other investors who put up the money and expect a return.

When market conditions change and investors are less plentiful, it becomes more difficult to find the investors to pay the money. Therefore rates need to go up to ensure the deals are made. The mortgage lenders on the front line cannot reduce the amount of interest they are charging because of the deal they have made with the investors, so there is no choice but to hope those who took out the mortgage can afford to pay it back. When they can’t, everyone loses out and that is what has led us to the current situation.

Danielle is an author of several articles pertaining to Mortgages. He is known for his expertise on the subject and on other Business and Finance related articles.