Financial Shock: Subprime Précis
Until recent events, few outside the real estate industry had even heard of a subprime mortgage. But this formerly obscure financial vehicle has grabbed the world’s attention because of its ravaging effect on the global economy and financial system.
Simply defined, a subprime mortgage is just a loan made to someone with a weak or troubled credit history. Historically, it has been a peripheral financial phenomenon, a marginal market involving few lenders and few borrowers. However, subprime home buyers unable to make good on their mortgage payments set off a financial avalanche in 2007 that pushed the global economy into its worst downturn since the Great Depression of the 1930s. Financial markets and the economy will ultimately recover, but the subprime financial shock will go down as a major inflection point in economic history.
The fuse for the subprime financial shock was set early in this decade, following the tech-stock bust, 9/11, and the invasions of Afghanistan and Iraq. With stock markets plunging and the nation in shock after the attack on the World Trade Center, the Federal Reserve Board (the Fed) slashed interest rates. By summer 2003, the federal funds rate—the one rate the Fed controls directly—was at a record low. Fearing that their own economies would slump under the weight of the faltering U.S. economy, other major central banks around the world soon followed the Fed’s lead.
In normal times, central bankers worry that lowering interest rates too much might spark inflation. If they worried less this time, a major factor was China. Joining the World Trade Organization in November 2001 not only ratified China’s arrival in the global market, but it lowered trade barriers and accelerated a massive shift of global manufacturing to the formerly closed communist mainland. As low-cost Chinese-made goods flooded markets, prices fell nearly everywhere and inflation seemed a remote concern. Policymakers even worried publicly about deflation, encouraging central banks to push rates to unprecedented lows.
China’s explosive growth, driven by manufacturing and exports, boosted global demand for oil and other commodities. Prices surged higher. This pushed up the U.S. trade deficit, as hundreds of billions of dollars flowed overseas to China, the Middle East, Russia, and other commodity-producing nations. Many of these dollars returned to the United States as investments, as Asian and Middle Eastern producers parked their cash in the world’s safest, biggest economy. At first they mainly bought U.S. Treasury bonds, which produced a low but safe return. Later, in the quest for higher returns, they expanded to riskier financial instruments, including bonds backed by subprime mortgages.