Subprime Meltdown

Following the tech bubble and the events of September 11, the Federal Reserve stimulated a struggling economy by cutting interest rates to historically low levels. As a result, a housing bull market was created. People with poor credit got in on the action when mortgage lenders created non-traditional mortgages: interest-only loans, payment-option ARMs and mortgageswith extended amortization periods. Eventually, interest rates climbed back up and many subprime borrowers defaulted when their mortgages were reset to much higher monthly payments. This left mortgage lenders with property that was worth less than the loan value due to a weakening housing market. Defaults increased; the problem snowballed, and several lenders went bankrupt.

Investors and hedge funds also suffered because lenders sold mortgages they originated into the secondary market. Here the mortgages were bundled together and sold to investors as collateralized debt obligations (CDOs) and other mortgage-backed securities (MBSs). When the higher risk underlying mortgages started to default, investors were left with properties that were quickly losing value. In the wake of the meltdown, central banks released liquidity into the market place, which allowed struggling lenders and hedge funds to continue operations and make the necessary payments on their obligations.