Back in the early 2000's, there was an excess amount of capital globally available. The world did not even imagine there would be a global financial crisis and all investment managers were concerned about was where to invest their capital in order to make it grow. The demand was for low risk investments that paid decent return.
Such investment options were not easy to find, but United States mortgage market seemed perfect at the time. After all, everyone thought home prices can't fall.
Thanks to the securitization of mortgage market, available money started to flow in without much hesitation. Securitization allowed banks to essentially sell the mortgages and distribute credit risk to investors. Banks issuing mortgages were no longer required to hold them to maturity and selling them meant more funds, which enabled more loans and generated more transaction fees. In practice, products in question were mortgage backed securities and collateralized debt obligations.
A moral hazard was created because banks focused on processing mortgage transactions at the expense of the credit quality. As a result mortgage underwriting standards declined precipitously during the boom period. The use of automated loan approvals allowed loans to be made without appropriate review and documentation.
In 2007, 40% of all subprime loans resulted from automated underwriting. Mortgage fraud by lenders and borrowers increased enormously. Credit rating agencies increased the problem by giving investment-grade ratings to mortgage-based securities based on risky subprime mortgage loans. The AAA ratings enabled sale to investors and financed the housing boom. The rating agencies actually suffered from conflict of interest, as they were paid by investment banks that organize and sell structured securities.
Subprime mortgage market collapse
In March 2007, the United States sub-prime mortgage industry collapsed due to higher-than-expected home foreclosure rates, and more than 25 sub-prime lenders declared bankruptcy. Significant losses forced some of them to sell the businesses. New Century Financial, the country's largest sub-prime lender, witnessed an 84% drop in stock value after Justice Department began to investigate and filed for bankruptcy on April 2, 2007. The manager of the world's largest bond fund, PIMCO, warned in June 2007 that the sub-prime mortgage crisis was not an isolated event and would eventually take a toll on the economy and ultimately have an impact in the form of impaired home prices.
Among the first to sense the impact were the government-sponsored enterprises Fannie Mae and Freddie Mac. They began receiving government tax incentives in 1995 for purchasing mortgage backed securities which included loans to low income borrowers. From 2002 to 2006, as the United States subprime market grew 292% over previous years. Accordingly Fannie Mae and Freddie Mac combined purchases of subprime securities rose from $38 billion to around $175 billion per year.
By 2008, the Fannie Mae and Freddie Mac owned in total around $5.1 trillion in residential mortgages, about half the total United States mortgage market. The government-sponsored enterprises have always been highly leveraged, so when concerns arose in September 2008 regarding the ability to make good on their guarantees, the Federal government was forced to place the companies into a conservatorship, effectively nationalizing them at the taxpayers' expense.