This paper reviews the subprime mortgage crisis and its effect on the U.S. economy.
The subprime mortgage crisis first gained the public's attention when a steep rise in home foreclosures occurred in 2006, and then spiraled out of control in 2007. At that time the mortgage meltdown triggered a national financial crisis that went global within the year. As a result, consumer spending dropped, the housing market plummeted, foreclosure numbers rocketed, and the stock market was shaken. All these problems have caused furious debate among consumers, bankers, and lawmakers as to the causes and the possible solutions.
There are various theories to explain what led to the mortgage crisis. Many experts and economists believe that the crisis happened because of a number of factors in which subprime lending played a significant role.
The current mortgage meltdown began with the bursting of the U.S. housing bubble that began in 2001 and peaked in 2005. Bianco (3) defines a housing bubble as
"an economic bubble that occurs in local or global real estate markets. It is defined by rapid increases in the valuations of real property until unsustainable levels are reached in relation to incomes and other indicators of affordability. Following the rapid increases are decreases in home prices and mortgage debt that is higher than the value of the property."
Many economists believe that the U.S. housing bubble was caused at least in part by historically low interest rates. Because of concerns following the dot-com bubble in 2000 and the resulting recession that began in 2001, the Federal Reserve Board cut short-term interest rates from about 6.5% down to 1%. Some criticized Alan Greenspan, former Chairman of the Federal Reserve Board, for creating the housing bubble, since it was the Fed's policy on interest rates that inflated the bubble. Others argued that the Fed operated from inaccurate inflation numbers, so the Fed funds rate was probably held lower and for a longer time than it should have been.
From 2004 to 2006, the Fed raised interest rates 17 times, from 1% to 5.25%. By that time many economists predicted a housing market correction because of the over-valuation of homes during the bubble period.
Subprime borrowing was a key factor in the increase in home ownership rates and demand for housing during the bubble years. The U.S. ownership rate grew from 64% in 1994 to an all-time high of 69.2% in 2004. Some homeowners took advantage of the increased property values of their homes to refinance them with lower interest rates, and took out second mortgages to use for consumer spending. During this time, U.S. household debt as a percentage of income rose to 130% in 2007; this figure was 30% higher than the average amount earlier in the decade.
Along with the collapse of the housing bubble came high default rates on subprime, adjustable rate, Alt-A, and other loans made to higher-risk borrowers with lower income or lesser credit history than prime borrowers. Subprime mortgages totaled $600 billion in 2006 and accounted for approximately one-fifth of the U.S. home loan market. The amount of subprime loans climbed as rising real estate values led to lenders taking more risks. Some experts believe that Wall Street encouraged this type of risk-taking behavior by bundling the loans into securities that were sold to pension funds and other institutional investors.
A Federal Reserve study in 2007 reported that the average difference in mortgage rates between subprime and prime mortgages decreased from 2.8 percentage points in 2001 to 1.3 percentage points in 2007. This drop indicates that the risk premium that lenders required to offer a subprime loan declined. This decrease happened even though subprime borrower and loan characteristics declined overall during the 2001-2006 period, which decline should have had the opposite effect. Instead, the decline in the risk premium led to lenders considering higher-risk borrowers for loans, which pursuit of profit left more and more banks at risk of default for the high-risk loans they made.
Some economists blame the emergence during the boom years of a new kind of specialized mortgage lender for worsening the mortgage crisis. These lenders were not regulated like traditional banks. Along with the increase of unregulated lenders came a rise in the kinds of subprime loans that should have sounded an alarm. The following types of problem loans became commonplace:
Adjustable rate mortgages (ARMs)
Interest only mortgages
Stated (no proof of) income loans
NINJA (no income, no job or assets) loans
Such loans should have raised concerns about the quality of the loans if interest rates increased or if the borrower were to become unable to pay the mortgage.
Some experts believe that mortgage standards became lax because of a "moral hazard" -- that is, a lack of incentive to guard against risk because one is protected from its consequences - which occurred because each link in the mortgage chain collected profits while believing it was passing on the risk. Mortgage denial rates for conventional home loans that were reported under the Home Mortgage Disclosure Act dropped from 29% in 1998 to 14% in 2002 and 2003, which statistics support the argument that moral hazard led to lax lending standards.
Because mortgage brokers do not lend their own money, there is no direct correlation between loan defaults and their compensation. However brokers did earn higher commissions for selling ARMs. The Mortgage Bankers Association claimed that brokers profited from the home loan boom, but didn't do enough to determine whether borrowers could repay the loans, which inadequacy left lenders and banks with the resulting mortgage defaults.
Mortgage underwriters determine if the risk of lending to a given borrower under certain circumstances is acceptable. In 2007, 40% of all subprime loans were generated by automated underwriting, a process that meant minimal documentation and much quicker decisions. Many experts believe that lax controls and relying on shortcuts led to the approval of buyers that, under a less automated system, would not have been approved.
The practice of securitization also contributed to the mortgage meltdown. Securitization is a structured banking process in which assets, receivables or financial instruments are acquired, classified into pools, then offered as collateral for third-party investment. Using securitization, mortgage-backed securities (MBS) along with the tendency of rating agencies to assign investment grade ratings to MBS, insured that high risk loans could be originated, packaged, and the risk readily transferred to others. Alan Greenspan blamed the securitization of home loans, not the loans themselves, for causing the mortgage meltdown.
Credit rating agencies came under criticism for giving investment grade ratings to securitization transactions that involved subprime mortgages. Critics also point out that there was conflict of interest involved, since rating agencies are paid by the companies selling MBS to investors, such as investment banks. Ratings agencies such as Standard & Poor's corp., Moody's Investors Service Inc., and Fitch Ratings have come under fire for their role in questionable ratings on securities based on mortgage loans to U.S. borrowers with poor credit records.
Some economists believe that borrowers played a role in the mortgage crisis. Easy credit and the assumption that housing prices would continue to appreciate encouraged some borrowers to obtain ARMs that they would be able to afford after the initial incentive period, typically two to three years, had passed. Once housing prices started to decline due to the housing market correction and the bursting of the housing bubble, the option of refinancing that was readily available during the boom became much more difficult. Homeowners who could not refinance predictably started to default on their loans when the loans reset to substantially higher interest rates and payment amounts.
Other economists blame predatory borrowing for causing the crisis. According to one study that was done involving three million loans made from 1997 to 2006, applications with misrepresentations were found to be five times as likely to go into default. According to the Financial Crimes Enforcement Network, Suspicious Activity Reports of mortgage fraud increased by 1,411% between 1997 and 2005.
Members of the Senate Banking Committee blamed federal regulators for much of the mortgage crisis. Regulators in turn claimed that they lacked the authority to prevent the crisis.
Still other economists blame government policy for encouraging the development of the subprime meltdown through legislation such as the Community Reinvestment Act. They claim this legislation forced banks to lend to non-creditworthy customers.
What seems clear from the available analyses of the mortgage meltdown and subsequent decline of the U.S. economy is that there was no single cause of the financial crisis. The failure was caused by a catastrophic combination of circumstances which each contributed to the meltdown.
In my mind there is no doubt that all the factors discussed in this paper contributed to the financial crisis; some were much more critical than others, and their effects were more devastating. I have to place the behavior of the financial industry at the top of the list, given that they had…