The US housing bubble and the subprime mortgage crisis for dummies.

We've all heard countless alarmist (or maybe not) news reports with the phrases 'sub-prime mortgage crisis' and 'housing market bubble burst' repeatedly appearing before us.

I remember once in Econs class, a classmate once asked the teacher if we needed to understand the current US housing market crisis in preparation for our exams. I distinctly remember being very relieved that we didn't have to. I'd have to face a whole new bunch of economics jargon: bubble, mortgage, equity...huh? Anyway it's now time for me to do some homework, for my enlightenment and yours.

Bubble:
An economic bubble happens when trade is at prices higher than intrinsic values. In the housing market bubble, there is an over-valuation of property. Because it is often difficult to observe intrinsic values in real-life markets, bubbles are often identified only in retrospect, when a sudden drop in prices appears. Such drop is known as a crash or a bubble burst.

How do bubbles happen?
The appreciation of real estate prices has lured many to become homeowners, in anticipation of future appreciation of their house/asset. This belief is fueled by the confidence is housing as a good investment as well as speculation of future rise in prices. Other reasons for the surge in buying include the mania for home ownership (Bush's 2004 campaign slogan: "the ownership society") and low interest rates (interest rates after 2001-2002 recession were at the all-time low 1% before they were subsequently raised in 2004-2006 to 5.25%) which then translates to cheaper and easier borrowing. This is also further aggravated by easy access to loans through subprime borrowing (explanation below).

Mortgage:
A loan to finance the purchase of real estate, usually with specified payment periods and interest rates. The borrower (mortgagor) gives the lender (mortgagee) a legal claim on the property as security/guarantee for the loan.

How do bubbles burst?
As a result, the appreciation of home values far exceeded the income growth of many of these homebuyers. When the Federal Reserve raised interest rates, the cost of borrowing became too costly, hence the demand for property fell. Thus prices of real estate begin crashing.

How the two are linked:
When the housing market bubble bursts, the values of their property plummeted due to a glut of housing supply in the market. As a result many owners now hold negative equity - the value of the asset used to secure a loan is less than the outstanding balance on the loan. This means the borrower will both have lost the property and still be in debt.

Subprime lending:
Defines lending to 'risky' borrowers, borrowers with compromised credit history. the risk for lenders is often offset by higher interest rates, ie rates above the prime rates.

The housing market crash caused many subprime borrowers to default on their loan and subprime lenders to file for bankruptcy. How do they get bankrupt? To put it simply, financial institutions, banks, earn their revenue from the higher interest rate they earn from loans they give. A default on the loan would mean the bank has lost not only its profits from the anticipated interest rate revenue but also lost the mean to pay back the debt 'borrowed' from savings account holders or other financial institutions.

From here on, many homeowners cut back spending, lose their jobs...bla bla bla..recession!
If you want to know more, wikipedia is a great place to start ( and to end also ;} )