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.
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 happen?
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.
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
three factors of:
from community and government organizations to issue more mortgages to allow
more people to become homeowners,
seemingly endless expansion of the housing market making homes seem like
excellent security for mortgages, and
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.
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
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
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.
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.
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.
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.
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.
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
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.
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 crisis.
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
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.
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
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 States.
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
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 loans.
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 agreements.
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.