The Subprime Mortgage Crisis: Causes and Lessons Learned-Module 4 of 5

The Subprime Mortgage Crisis: Causes and Lessons Learned

Introduction

^{In 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.[1]} 

^{The Subprime Mortgage Crisis}

^{By 2007, real estate markets were over-saturated with over-priced homes being purchased by people who posed high credit risks.[2]  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.[3] Millions of families were left homeless. But how did this all happen?}  

^{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.”[4]  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.} 

^{Subprime loans started rising in popularity in the mid-1990’s.[5] 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.[6]  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.[7]}

^{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:}

^{1.     pressure from community and government organizations to issue more mortgages to allow more people to become homeowners,}

^{2.    the seemingly endless expansion of the housing market making homes seem like excellent security for mortgages, and}

^{3.    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.[8] Due to lax investigation procedures and the general loose credit atmosphere, these misrepresentations often went undetected.[9]}

^{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.[10]} 

^{In the early 2000s, nearly one-third of all ARMs had initial teaser rates below four percent.[11]  When that introductory grace period ended, interest rates skyrocketed and borrowers were often left with monthly repayment requirements they could not afford.[12]}

^{ARMs 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.[13] 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.[14]  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.[15]}

^{Real Estate and Financial Services Contribute to Financial Collapse}

^{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.[16]  In turn, borrowers took out loans for amounts that were more than the homes were worth in the open market.[17]  Some have even argued that appraisers’ overvaluation of homes was the real root of the financial crisis.[18]}  

^{Securitization 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.[19]  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.[20]}

^{The financial sector began securitizing mortgages in the late 1980s.[21]  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.[22] 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.[23]  Thus, lenders were incentivized to make as many home loans as possible.[24] 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[25] and the failure of Indymac, one of the largest mortgage originators in the United States.}

^{Congress Responds to the Economic Crisis}

^{Congress 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,[26] as well as the Consumer Financial Protection Act.[27]}

^{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.”[28]  This good faith determination forced lenders to tighten their underwriting standards, thus eliminating borrowers’ ability to qualify using devices such as stated income loans.} 

^{The Consumer Financial Protection Act regulates aspects the consumer finance market, including home lending.[29]  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.[30]  To foster this incentive, the Bureau simplified traditional mortgage disclosure forms and created standardized industry practices that were more transparent.[31]  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 agreements.[32]}

^{The 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.[33]  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.[34]}

^Conclusion

There 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.[35] 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.[36]  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.

[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203,§ 929-Z, 124 Stat. 1376, 1871 (2010) (codified at 15 U.S.C. § 780)

[2]  David Jones, Bad Appraisals: Getting to the root of the subprime mortgage crisis, The Real Deal, https://therealdeal.com/issues_articles/bad-appraisals-getting-to-the-root-of-the-subprime-crisis-2/ (Dec. 05, 2007); New home sales fell by record amount in 2007, Associated Press, (Jan. 28, 2008 8:44 PM), http://www.nbcnews.com/id/22880294/ns/business-real_estate/t/new-home-sales-fell-record-amount/#.WpsOlWbMzVp 

[3] Kimberly Amadeo, What Caused the Subprime Mortgage Crisis, The Balance, (July 06, 2017), https://www.thebalance.com/what-caused-the-subprime-mortgage-crisis-3305696

[4]  Ben S. Bernanke, Chairman, The Subprime Mortgage Market, The Fed. Reserve, (May, 17 2007) https://www.federalreserve.gov/newsevents/speech/bernanke20070517a.htm

[5]  Id.

[6]  The Subprime Mortgage Crisis, The Univ. of N.C. at Chapel Hill, www.stat.unc.edu/faculty/cji/fys/2012/Subprime%20mortgage20crisis.pdf ; Chris Arnold, Economists Brace for Worsening Subprime Crisis, Nt’l Pub. Radio, https://www.npr.org/templates/story/story.php?storyId=12561184; Ben S. Bernanke, Chairman, Fostering Sustainable Homeownership, The Fed. Reserve,https://www.c-span.org/video/?204356-1/fostering-sustainable-homeownership.

[7]  Id.

[8]  Katalina M. Bianco, The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown, CCH,http://business.cch.com/images/banner/subprime.pdf.

[9] https://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are-still-being-felt-five-years-article

[10]  Chris Arnold, Economists Brace for Worsening Subprime Crisis, Nat’l Pub. Radio, https://www.npr.org/templates/story/story.php?storyId=12561184; Christopher L. Foote, et al., Subprime Facts: What (We Think) We Know about the Subprime Mortgage Crisis and What We Don’t, Fed. Reserve Bank of Boston, May 30, 2008.

[11]  Arnold, supra note 9.

[12]  Interestingly, some economists argue this teaser rate “reset” did not contribute to the crisis, and that “interest-rate resets, although not trivial, were not explosive.”  Foote, supra note 9.

[13]  The Subprime Mortgage Crisis, The Univ. of N.C. at Chapel Hill, www.stat.unc.edu/faculty/cji/fys/2012/Subprime%20mortgage20crisis.pdf.

[14] Piggyback Loan, LendingTree, https://www.lendingtree.com/glossary/what-is-piggyback-loan (last visited Mar. 3, 2018).

[15] What is private mortgage insurance, Consumer Fin. Prot. Bureau, https://www.consumerfinance.gov/ask-cfpb/what-is-private-mortgage-insurance-en-122/ (last updated July 28, 2017).

[16]  A 2003 study suggests fifty-five percent of appraisers reported they felt pressured by mortgage lenders, brokers, and consumers to inflate home values.  David Jones, Bad Appraisals: Getting to the root of the subprime mortgage crisis, The Real Deal, https://therealdeal.com/issues_articles/bad-appraisals-getting-to-the-root-of-the-subprime-crisis-2/ (Dec. 05, 2007). 

[17] Id.

[18]  Id; see also Ned Bushong, You’re All Wrong.  Blame the APPRAISERS for The Mortgage Crisis, Business Insider, http://www.businessinsider.com/youre-all-wrong-blame-the-appraisers-for-the-mortgage-crisis-2010-4 (Apr. 7, 2010,  11:22 AM).

[19]  Stephen Hoffman, Dodd-Frank, Securitization, and the Subprime Mortgage Crisis 6 (Sept. 12, 2012) (unpublished manuscript) (on file with Social Science Research Network), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2145210 (describing problems in the supervision of the subprime-mortgage market).

[20] Id.

[21]  Alessandro Bruno, The 2008 Financial Crisis Explained, Lombardi Letter (May 18, 2007), https://www.lombardiletter.com/the-2008-financial-crisis-explained/11672/.

[22]  Id; see also Hoffman, supra note 18.

[23]  Id.

[24]  Id.

[25] https://www.nytimes.com/2008/09/15/business/15lehman.html

[26]  Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 929-Z, 124 Stat. 1376, 1871 (2010) (codified at 15 U.S.C. § 780) at § 1400 et seq [hereinafter Dodd-Frank Act]

[27]  Dodd-Frank Act § 1001 et seq.

[28]  Raj Date, Lessons Learned from the Financial Crisis: The Need for the CFPB, CFPB (Sept. 15, 2011), https://www.consumerfinance.gov/about-us/newsroom/lessons-learned-from-the-financial-crisis-the-need-for-the-cfpb/; Know Before You Owe: Mortgages, CFPB (Nov. 20, 2013) https://files.consumerfinance.gov/f/201311_cfpb_factsheet_kbyo_mortgage-disclosures.pdf.

[29]  Raj Date, Lessons Learned from the Financial Crisis: The Need for the CFPB, CFPB (Sept. 15, 2011) https://www.consumerfinance.gov/about-us/newsroom/lessons-learned-from-the-financial-crisis-the-need-for-the-cfpb/.

[30] Id; see also, Know Before You Owe: Mortgages, CFPB (Nov. 20, 2013) https://files.consumerfinance.gov/f/201311_cfpb_factsheet_kbyo_mortgage-disclosures.pdf.

[31] Know Before You Owe: Mortgages, CFPB (Nov. 20, 2013) https://files.consumerfinance.gov/f/201311_cfpb_factsheet_kbyo_mortgage-disclosures.pdf.

[32] https://www.consumerfinance.gov/owning-a-home/

[33]  David D. McElroy, Recent Reforms and Developments in Mortgage Law and Finance, 25 J. Tax’n F. Inst. 43,4 (Nov.-Dec. 2011); https://www.skadden.com/insights/publications/2015/01/regulators-adopt-final-risk-retention-rules-for-as

[34] Andrew M. Faulkner, Regulators Adopt Final Risk Retention Rules for Asset-Backed Securities, Skadden (Jan. 2015) https://www.skadden.com/insights/publications/2015/01/regulators-adopt-final-risk-retention-rules-for-as

[35]  Kimberly Amadeo, What Caused the Subprime Mortgage Crisis?, The Balance (July 06, 2017), https://www.thebalance.com/what-caused-the-subprime-mortgage-crisis-3305696.

[36]Dodd-Frank Act, Pub. L. No. 111-203, § 929-Z, 124 Stat. 1376, 1871 (2010).