Credit Market Freeze – Causes and its Importance
February 12, 2025
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The subprime mortgage crisis was basically a clash of ideologies. These ideologies were related to the centuries old belief regarding how money should be lent out versus the new age beliefs regarding how money should be lent out.
The old age belief was that money is being lent out to the borrower and that collateral should be set aside and the borrower’s ability to pay back should be taken into account.
In this article we will have a closer look at the clash between the two approaches.
The borrower approach was based on centuries of sound lending practices. This is how money had always been lent out. Some of the maxims of this old age approach have been listed below:
The assumption would be that the borrower will not be able to pay back and the documentation would be used to create a case otherwise. Each document was looked at with extreme skepticism.
Detailed analyses of what the borrower’s cash flows would look like in the future were drawn out. There were heuristics which governed the amount of money that the borrower must pay towards the mortgage in case they were to maintain their lifestyle and not face any liquidity crunch.
The new age lending analysis simply discounted the borrower and the old adage. They simply believed that it was the borrower’s job to look at their budget and not the bank’s. The bank was lending against collateral i.e. a house and if the borrower failed to pay back the money, well they would simply foreclose the house and obtain their money!
This was done by closely scrutinizing the past debts that were held by the borrower. Were they paid back on time? Did the borrower follow the repayment schedule or was there a delay in making the payments? Did the borrower have any incidences of bankruptcies or foreclosures?
The new age lending has a much better mechanism to keep a track record of all the above questions. This mechanism is called the “credit score” and it aggregates all the above questions into one easy to understand number.
However, competition between the new age bankers led them to believe that this number was not as important as it seemed to be. The rationale once again was the same. The transaction is secured with a house of greater value and hence they shouldn’t really be worrying about all these things.
Mortgages after all lasts for about three decades on an average and a lot can change regarding the valuation of the property in that time frame.
Also, the lenders would assume what would happen if distressful scenarios such as divorce, illness or any other expense were to come the borrower’s way. Only if the borrower’s outlook was positive in all of these scenarios were the loans made.
The new age lending practice was the exact opposite of this. Down payments were reduced to a minimum. Also, there were soft second loans available to help borrowers make the margin payment. Therefore in essence the bank was financing 100% of the property instead of 80%. No attention was paid to any duress that the borrower may face in their lives.
The collateral approach to lending had some major flaws. These flaws were what later caused the subprime debacle. Two of the most prominent flaws in this approach have been listed down below:
In fact it is a lose-lose scenario if the defaults happen in mass. This is because properties are not like stocks and bonds, they cannot be sold overnight.
In fact property investments can take months to liquidate. On top of that there are legal expenses and transaction costs that need to be borne by the banks too.
Hence, if the borrower defaults the bank is stuck with a property. But the banks are not in the business of leasing properties. Instead they are in the business of lending out money and it takes a long time to convert the property into money!
In the absence of any margin money, banks literally have to write off millions of dollars in losses. This is precisely what happened as result of the subprime mortgage crisis.
The bottom line therefore is that collateral is meant to make lending easier. It is not the sole purpose of lending. The age old maxim still holds true. Loans are still made to borrowers and a thorough credit check is the only way to ensure sustainable profitable lending.
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