This article provides background information regarding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.
Subprime lending The U.S. Federal Deposit Insurance Corporation (FDIC) has defined subprime borrowers and lending: "The term subprime refers to the credit characteristics of individual borrowers. Subprime borrowers typically have weakened credit histories that include payment delinquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories. Subprime loans are loans to borrowers displaying one or more of these characteristics at the time of origination or purchase. Such loans have a higher risk of default than loans to prime borrowers."FDIC-Guidance for Subprime Lending If a borrower is delinquent in making timely mortgage payments to the loan servicer (a bank or other financial firm), the lender may take possession of the property, in a process called foreclosure.
A plain-language overview
The following is excerpted (with some modifications) from former U.S. President George W. Bush's Address to the Nation on September 24, 2008:President's Address to the Nation Other additions are sourced later in the article or in the main article.
"The problems we are witnessing today developed over a long period of time. For more than a decade, a massive amount of money flowed into the United States from investors abroad. This large influx of money to U.S. banks and financial institutions — along with low interest rates — made it easier for Americans to get credit. Easy credit — combined with the faulty assumption that home values would continue to rise — led to excesses and bad decisions."
Many mortgage lenders approved loans for borrowers without carefully examining their ability to pay. Many borrowers took out loans larger than they could afford, assuming that they could sell or refinance their homes at a higher price later on. Both individuals and financial institutions increased their debt levels relative to historical norms during the past decade significantly.
Optimism about housing values also led to a boom in home construction. Eventually the number of new houses exceeded the number of people willing to buy them. And with supply exceeding demand, housing prices fell. And this created a problem: Borrowers with adjustable rate mortgages (i.e., those with initially low rates that later rise) who had been planning to sell or refinance their homes before the adjustments occurred were unable to refinance. As a result, many mortgage holders began to default as the adjustments began.
These widespread defaults (and related foreclosures) had effects far beyond the housing market. Home loans are often packaged together, and converted into financial products called "mortgage-backed securities". These securities were sold to investors around the world. Many investors assumed these securities were trustworthy, and asked few questions about their actual value.
Credit rating agencies gave them high-grade, safe ratings. Two of the leading sellers of mortgage-backed securities were Fannie Mae and Freddie Mac. Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put the financial system at risk.
The decline in the housing market set off a domino effect across the U.S. economy. When home values declined and adjustable rate mortgage payment amounts increased, borrowers defaulted on their mortgages. Investors globally holding mortgage-backed securities (including many of the banks that originated them and traded them among themselves) began to incur serious losses. Before long, these securities became so unreliable that they were not being bought or sold.
Investment banks such as Bear Stearns and Lehman Brothers found themselves saddled with large amounts of assets they could not sell. They ran out of the money needed to meet their immediate obligations and faced imminent collapse. Other banks found themselves in severe financial trouble. These banks began holding on to their money, and lending dried up, and the gears of the American financial system began grinding to a halt.
Precursor, "Subprime I" Although most references to the Subprime Mortgage Crisis refer to events and conditions that led to the 2008 financial crisis and the Great Recession, a much smaller bubble and collapse occurred in the mid- to late-1990s, sometimes dubbed "Subprime I"McLean, Bethany and Joe Nocera, All the Devils Are Here: The Hidden History of the Financial Crisis Portfolio, Penguin, 2010, p.82, 83, 86, 89, 144 or "Subprime 1.0".Resisting Corporate Corruption: Cases in Practical Ethics From Enron Through ...| By Stephen V. Arbogast| Wiley It ended in 1999 when the rate of subprime mortgage securitization dropped from 55.1% in 1998 to 37.4% in 1999. In the two years following the 1998 Russian financial crisis, "eight of the top ten" subprime lenders "declared bankruptcy, ceased operations, or sold out to stronger firms."Financial Crisis Inquiry Report, p.74-75
The crisis is said to have had "all the earmarks of a classic bubble" with enthusiasm over rising stock prices replacing caution over shoddy business practices and concern over whether the earnings of the companies were sustainable. Loans were made to borrowers who were unable to pay them back. The subprime mortgage companies began taking unexpected write-downs as mortgages were refinanced at lower interest rates. Much of the reported profits turned out to be illusory and companies such as Famco went under. Along with the bankruptcies came a wave of lawsuits and complaints from consumer advocates, who accused the subprime industry of engaging in predatory lending. The impact was slight compared to the later bubble.
Subprime I was smaller in size — in the mid-1990s $30 billion of mortgages constituted "a big year" for subprime lending, by 2005 there were $625 billion in subprime mortgage loans, $507 billion of which were in mortgage backed securities — and was essentially "really high rates for borrowers with bad credit". Mortgages were mostly fixed-rate, still required borrowers to prove they could pay by documenting income, etc.McLean, Bethany and Joe Nocera, All the Devils Are Here, the Hidden History of the Financial Crisis Portfolio, Penguin, 2010, p.144 By 2006, 75% of subprime loans were some form of floating-rate, usually fixed for the first two years."The Big Short, Michael Lewis, p.23
Background to the crisis In 2006, Lehman Brothers and Bear Stearns, whose fixed-income franchises benefitted from having integrated mortgage origination businesses, were seen as runaway success stories. Many more investment banks had already built large mortgage desks, and invested heavily in subprime platforms. Mortgage origination and securitization generated lucrative fees during the time when the US market developed away from the traditional agency/CMO model.Have Wall Street banks gone subprime at the wrong time?
Fannie Mae and Freddie Mac shrunk their balance sheets substantially as conforming mortgage origination volumes diminished, and private label securitization grew substantially from 2002. Large-scale defaults from subprime lending had yet to hit headlines in 2006; rating agencies began sounding early alarm bells in the summer of 2006 but it was anticipated delinquencies would go up with the biggest rollovers on the new loans (around 2008).
Stages of the crisis The crisis has gone through stages. First, during late 2007, over 100 mortgage lending companies went bankrupt as subprime mortgage-backed securities could no longer be sold to investors to acquire funds. Second, starting in Q4 2007 and in each quarter since then, financial institutions have recognized massive losses as they adjust the value of their mortgage backed securities to a fraction of their purchased prices. These losses as the housing market continued to deteriorate meant that the banks have a weaker capital base from which to lend. Third, during Q1 2008, investment bank Bear Stearns was hastily merged with bank JP Morgan with $30 billion in government guarantees, after it was unable to continue borrowing to finance its operations.Frontline-Inside the Meltdown
Fourth, during September 2008, the system approached meltdown. In early September Fannie Mae and Freddie Mac, representing $5 trillion in mortgage obligations, were nationalized by the U.S. government as mortgage losses increased. Next, investment bank Lehman Brothers filed for bankruptcy. In addition, two large U.S. banks (Washington Mutual and Wachovia) became insolvent and were sold to stronger banks.Wachovia & Wamu The world's largest insurer, AIG, was 80% nationalized by the U.S. government, due to concerns regarding its ability to honor its obligations via a form of financial insurance called credit default swaps.Frontline - Inside the Meltdown
These sequential and significant institutional failures, particularly the Lehman bankruptcy, involved further seizing of credit markets and more serious global impact. The interconnected nature of Lehman was such that its failure triggered system-wide (systemic) concerns regarding the ability of major institutions to honor their obligations to counterparties. The interest rates banks charged to each other (see the TED spread) increased to record levels and various methods of obtaining short-term funding became less available to non-financial corporations.
It was this "credit freeze" that some described as a near-complete seizing of the credit markets in September that drove the massive bailout procedures implemented by worldwide governments in Q4 2008. Prior to that point, each major U.S. institutional intervention had been ad-hoc; critics argued this damaged investor and consumer confidence in the U.S. government's ability to deal effectively and proactively with the crisis. Further, the judgment and credibility of senior U.S. financial leadership was called into question.
Since the near-meltdown, the crisis has shifted into what some consider to be a deep recession and others consider to be a "reset" of economic activity at a lower level, now that enormous lending capacity has been removed from the system. Unsustainable U.S. borrowing and consumption were significant drivers of global economic growth in the years leading up to the crisis. Record rates of housing foreclosures are expected to continue in the U.S. during the 2009–2011, continuing to inflict losses on financial institutions. Dramatically reduced wealth due to both housing prices and stock market declines are unlikely to enable U.S. consumption to return to pre-crisis levels.Roubini-10 Risks to Global Growth
Thomas Friedman summarized how the crisis has moved through stages:
Alan Greenspan has stated that until the record level of housing inventory currently on the market declines to more typical historical levels, there will be downward pressure on home prices. As long as the uncertainty remains regarding housing prices, mortgage-backed securities will continue to decline in value, placing the health of banks at risk.Greenspan Op Ed WSJ
The subprime mortgage crisis in context Economist Nouriel Roubini wrote in January 2009 that subprime mortgage defaults triggered the 2008 financial crisis, but were part of multiple credit bubble collapses.Roubini - More Doom Ahead It is the bursting of the many bubbles that he believed caused this crisis to spread globally and magnify its impact.
Fed Chairman Ben Bernanke summarized the crisis as follows during a January 2009 speech: