The Subprime Mortgage Crisis: Causes and Lessons Learned
the late 2000’s, a series of economic conditions came together to cause a major
downturn in real estate and mortgage finance markets. This “bursting” of the
real estate bubble created a ripple effect throughout the economy that is now
referred to as the subprime mortgage crisis.
The impacts of the crisis were
global in scale. In this module, we will look at what common mortgage practices
in the United States lead to the crisis and how the government responded to the
collapse. We will highlight some of the most prominent factors that contributed
to the greatest economic pullback since the Great Depression of the 1930s.
After investigating the causes of the economic recession, the discussion then
turns to how Congress responded with the Dodd-Frank Wall Street Reform and
Consumer Protection Act.
The Subprime Mortgage Crisis
2007, real estate markets were over-saturated with over-priced homes being
purchased by people who posed high credit risks. Lenders gave out expensive
mortgages during a real estate boom that people seemed to think would last
forever. As real estate values slipped, many of these mortgages amounted to
more than the homes’ total values. Many homeowners found themselves unable to
afford their monthly mortgage payments, and they could no longer refinance or
sell due to plummeting real estate values. Millions of Americans who were
behind on their mortgages had no way of avoiding default. This harrowing
combination led to borrowers defaulting on their home loans in record numbers,
with nearly five million homes foreclosed upon between 2008 and 2014. Millions of families were left homeless. But how did this all
The financial collapse of 2007 to
2009 is commonly referred to as the subprime mortgage crisis because this lending practice is considered the main trigger of the
collapse. The Federal Reserve defines subprime mortgages
as “loans made to borrowers who are perceived to have
high credit risk, often because they lack a strong credit history or have other
characteristics that are associated with high probabilities of default.” The “subprime” qualifier
thus refers to the borrower’s credit rating, not the loan itself. In other words, subprime lending practices
extended mortgage loans to people who would have typically been denied credit
under more conservative financial policies.
loans started rising in popularity in the
mid-1990’s. In 1994, total subprime mortgage loans issued in the United
States amounted to $35 billion. By 1999, that number has more than quadrupled
to $160 billion. This trend continued after
the turn of the millennium, and lenders were soon giving out hundreds of
billions of dollars in risky loans. In 2006, just one year before the financial
crisis officially hit, lenders issued $600 billion in subprime mortgage loans.
At around the same time in American
history, it became common for banks issuing mortgages to sell them to large
investment banks, who would resell or trade large numbers of mortgages by
creating enormous securities made up of mortgage interests. It became common,
and still is common, for banks to issue mortgages and turnaround and sell those
mortgages to other banks or investment banks within days.
The three factors of:
pressure from community and government
organizations to issue more mortgages to allow more people to become
the seemingly endless expansion of
the housing market making homes seem like excellent security for mortgages, and
the fact that issuing banks were
unlikely to keep and have to collect on the mortgages they issued
… all combined to create an
atmosphere where and banks had every incentive to loosen the qualifications and
requirements for mortgages.
In this environment, it is perhaps
unsurprising that banks found themselves issuing more and more mortgages to
people who were less and less qualified. Not only were these loans issued to risky
borrowers, as much as seventy percent of the applications for these loans may
have contained false information. Commonly, applicants would make false
statements about income or create false income verification documents.
Due to lax investigation procedures and the general loose credit atmosphere,
these misrepresentations often went undetected.
Lending Practices that Contributed to the Crisis
Prior to 2007, lenders were very
eager to issue mortgages. Many in the industry believed that if people found
themselves unable to pay their mortgages, they would simply sell their home for
a profit in the booming housing market and use the proceeds to pay off the
loan. As a result, lenders commonly employed innovative lending tactics to
entice subprime borrowers.
Predominantly, these tactics included adjustable rate mortgages with
teaser rates and tricky underwriting practices.
Before the financial collapse,
lenders commonly advertised adjustable-rate mortgages with teaser interest
rates. These mortgages offered low
introductory interest rates for a brief “teaser” period, during which time
borrowers had lower monthly payments.
For example, the most common type teaser ARMs prior to 2007 were 2/28
ARMs. These mortgages allowed the borrower to pay a fixed low interest rate for
the first two years of repayment, with the remaining twenty-eight years subject
to an adjustable interest rate that reset every six months.
In the early 2000s, nearly
one-third of all ARMs had initial teaser rates below four percent. When that introductory
grace period ended, interest rates skyrocketed and borrowers were often left
with monthly repayment requirements they could not afford.
with teaser rates and other excessively risky mortgage loans were made possible
by lax standards in underwriting and credit verification standards. Typically,
underwriters verify a potential borrower’s ability
to repay a loan by requiring the potential borrower to provide a plethora of
financial documents. Underwriters are expected to review bank account
statements, pay stubs, W-2s, several years’ worth of tax returns, and similar
documents to get a clear, evidence-based picture of a mortgage borrower’s
finances. Over time, however, underwriters started to require
less and less documentation to verify the potential borrower’s financial representations. In fact, with the rise of subprime
mortgage lending, lenders began relying on various forms of “stated” income or
“no income verification” loans. Borrowers could simply state their incomes
rather than providing documentation for review.
Most prevalent among these types of
mortgages were stated income verified assets loans, where lenders
extended credit based on the borrowers’ stated income and asset levels. An
underwriter was required to verify borrowers’ assets, but not their incomes.
Another common type of stated
income loans was a no income verified assets loans, in which
underwriters verified assets but did not look into whether the potential
borrower was employed or had other sources of income.
The third, and perhaps most
irresponsible, common type of stated income loan was known as a no income, no
job or asset loans (known as “NINJA” loans). NINJA loans could be approved with
no financial documentation on the borrower’s application. NINJA mortgages were
issued without any independent verification of the borrower’s ability to repay
the loan. Unsurprisingly, many of these borrowers turned out to be unable
to pay their mortgages.
Low underwriting standards fostered
an environment where people who posed a real credit risk were able to obtain
home loans. Often, subprime borrowers were targeted for predatory loans with
complex and harsh provisions. In fact, special mortgage loans were created just
for borrowers who were unable to come up with the cash for a down payment.
Under a so-called “piggyback” loan, a mortgage lender would issue one loan to
cover the down payment and closing costs, and then a second loan to cover the
home’s purchase price. These loans allowed borrowers to purchase
homes with zero down payment and avoid paying private mortgage
insurance—insurance designed to protect the lender should the borrower default.
Real Estate and Financial Services Contribute to Financial
Improper mortgage lending practices
played a large role in the financial collapse. However, this is still not the
whole story. In fact, activities in real estate and secondary financial
services markets contributed a great deal to the larger economic problems the
country experienced during the recession.
To start with, homes were being
appraised at excessively high values, inflating real estate prices across the
country. During the booming housing market of the 1990s and early
2000s, appraisers routinely overvalued homes or employed incomplete valuation
methods. This caused inflated housing values to circulate in real estate
markets. In turn, borrowers took
out loans for amounts that were more than the homes were worth in the open
market. Some have even argued that appraisers’ overvaluation of homes was the real root of the financial
of mortgage loans may have been the straw that broke the camel’s back. Securitization is a necessary and common practice in the
financial markets. Securitization is the
practice of converting assets – like mortgages – into securities – like stocks
and bonds – by pooling assets together and collecting regular income streams
from the newly-formed securities.
The financial sector began securitizing
mortgages in the late 1980s. Doing so allowed lenders
to mitigate some of the risk of giving out subprime loans because the debt was
pooled and re-issued to securities investors. The default of a few subprime mortgages could be compensated for
by the profits generated by the ones that were paid properly.
This process was immensely profitable, and
lenders believed they would profit regardless of whether any one borrower went
into default. After all, if they didn’t make money off of the loan, they could
still make money by issuing securities or by selling the home through
foreclosure if the borrower defaulted. Thus, lenders were
incentivized to make as many home loans as possible. As a result, banks began ramping up the lucrative practice of
securitizing mortgage loans and selling collateralized debt obligations.
Of course, the concept of spreading the risk only works when most of the
loans are paid back. If too high a percentage of the loans are defaulted on,
the securities’ values plummet. At that point, the investment banks that are
left holding these enormous securities are forced to take huge portfolio
losses. These losses caused the failure of large investment banks like Bear
Sterns and Lehman Brothers and the
failure of Indymac, one of the largest mortgage originators in the United
Congress Responds to the Economic Crisis
enacted the Dodd-Frank Act in response to these conditions with the intent of
preventing a similar catastrophe in the future. The legislation was extensive,
creating a new federal agency—the Consumer Financial Protection
Bureau — and reforming practices in both the real estate industry and financial
sector. Dodd-Frank overhauled mortgage
lending practices, heightened oversight of banks and credit rating agencies,
and included a whistle-blower provision that provides financial reward for the reporting
of securities violations. The Dodd-Frank Act was a
far-reaching law, and it included the Mortgage Reform and Anti-Predatory
Lending Act, as well as the Consumer Financial Protection Act.
The Act delegated rulemaking and
enforcement to the newly minted Consumer Financial Protection Bureau. Further, it modified aspects of Regulation Z
and amended aspects of the Truth in Lending Act. The Act required originators to prioritize the borrower’s ability to repay the loan during the application process. Similarly, lenders are required to make a
“good faith determination as to a consumer’s ability to repay the loan.” This good faith
determination forced lenders to tighten their underwriting standards, thus
eliminating borrowers’ ability to qualify using devices such as stated income
Consumer Financial Protection Act regulates aspects the consumer finance
market, including home lending. To combat predatory
lending, the Consumer Financial Protection Bureau passed the Know Before You
Owe mortgage disclosure rule, which is designed to help borrowers
understand their loans, and the accompanying documents they sign. To foster this incentive,
the Bureau simplified traditional mortgage disclosure forms and created
standardized industry practices that were more transparent. Moreover, the Bureau manages
an online legal toolkit that provides consumers with various resources and
educates them on the home-buying process, intending to reduce borrowers’
susceptibility to predatory lending and willingness to enter into risky loan
Dodd-Frank Act mitigated a great deal of unnecessary risk in real estate
lending markets and shifted some of the remaining risk of default from
homeowners to lenders. Under
the law, lenders sponsoring asset-backed securities must retain at least five
percent of the associated credit risk.
Many believe this requirement will reduce lenders’ willingness to issue
subprime loans. While this makes it more
difficult for some, potentially unqualified, borrowers to obtain a mortgage, it
is expected to improve the quality of the mortgage-backed securities being
issued and support a healthier lending market nationwide.
was no one single cause to the financial crisis of the late-2000s. Rather, the economic recession was due to activities across
banking, lending, and real estate markets. However, the main culprit was
mortgage-backed securities, collaterized debt obligations, and rising
adjustable mortgage interest rates on both prime and subprime loans. After the real estate bubble burst, Congress responded with the
sweeping Dodd-Frank legislation, which included the Mortgage Act and the
Consumer Financial Protection Act. Now that more than a decade
has passed since these major reforms were passed, mortgage lending practices
have evolved to comply with the new practices required by the law.